Real Estate Financing Explained: Loans, Mortgages & LTV

Financing is the engine that makes most real estate transactions possible. On the licensing exam, the financing domain typically accounts for 8–12% of the national portion, and the questions range from straightforward definitions to multi-step calculation problems. This guide covers everything you need to know: loan types, mortgage instruments, key ratios, lending laws, and the foreclosure process.

Mortgage Instruments: The Legal Framework

Before diving into loan types, you need to understand the legal instruments that create a mortgage loan. There are two key documents, and they serve different purposes:

• Promissory Note: The borrower's personal promise to repay the debt. It specifies the loan amount, interest rate, payment schedule, and terms of repayment. The note is the evidence of the debt — it creates personal liability for the borrower.
• Mortgage (or Deed of Trust): The security instrument that pledges the property as collateral for the loan. If the borrower defaults on the promissory note, the lender can foreclose on the property. In lien theory states, the mortgage creates a lien but the borrower retains title. In title theory states, the lender holds legal title until the loan is repaid.

The concept of hypothecation is central here: the borrower pledges the property as security without giving up possession or use. You live in the house, you control the house, but the lender has a claim against it if you stop paying.

Major Loan Types

The exam expects you to know the distinguishing features of each major loan category:

Conventional Loans

Conventional loans are not insured or guaranteed by the federal government. They typically require higher down payments (often 20%) and stricter credit qualifications. If the loan-to-value ratio exceeds 80%, the borrower must pay for private mortgage insurance (PMI), which protects the lender — not the borrower — in case of default. Conventional loans can be conforming (meeting Fannie Mae/Freddie Mac limits) or non-conforming (jumbo loans exceeding those limits).

FHA Loans

Federal Housing Administration loans are government-insured, not government-made. The FHA insures the lender against loss, which allows lenders to offer more favorable terms: lower down payments (as low as 3.5%), more flexible credit requirements, and competitive interest rates. FHA loans require both an upfront mortgage insurance premium (UFMIP) and an annual mortgage insurance premium (MIP), typically for the life of the loan. They also have maximum loan limits that vary by county.

VA Loans

Department of Veterans Affairs loans are available to eligible veterans, active-duty service members, and certain surviving spouses. The VA guarantees a portion of the loan, enabling lenders to offer extremely favorable terms: zero down payment, no PMI, competitive rates, and limits on closing costs. The key exam point: VA loans are guaranteed, not made, by the government. The veteran must still qualify with the lender.

USDA Loans

United States Department of Agriculture loans are designed for rural and certain suburban homebuyers. They offer zero down payment and competitive rates, but are restricted to designated rural areas and have income limits (typically 115% of the area median income).

Loan-to-Value Ratio (LTV) and Discount Points

Two calculations appear frequently on the exam:

Loan-to-Value Ratio

LTV = Loan Amount ÷ Property Value (or Purchase Price, whichever is lower). A buyer purchasing a $300,000 home with a $240,000 loan has an LTV of 80% ($240,000 ÷ $300,000). Lenders use LTV to assess risk — higher LTV means less borrower equity and more lender exposure. Most conventional lenders require PMI when LTV exceeds 80%. The exam may ask you to calculate the maximum loan amount given a required LTV, or to determine whether PMI is required.

Discount Points

Discount points are prepaid interest that the borrower pays at closing to "buy down" the interest rate. One point costs 1% of the loan amount. On a $200,000 loan, one point costs $2,000. Each point typically reduces the interest rate by 0.25% (though the exact reduction varies by lender). The exam may ask you to calculate the cost of points or to determine the break-even point — how long it takes for the monthly savings from the lower rate to exceed the upfront cost of the points.

Loan Payment Structure: PITI and Amortization

Most residential mortgage payments consist of four components, remembered by the acronym PITI:

• Principal: The portion of the payment that reduces the loan balance.
• Interest: The cost of borrowing, calculated on the remaining loan balance.
• Taxes: Property taxes, collected monthly by the lender and held in an escrow (impound) account, then paid to the taxing authority when due.
• Insurance: Hazard insurance premiums, also collected monthly and held in escrow.

With a fully amortized loan, each payment covers all interest due plus enough principal to reduce the balance to zero by the end of the loan term. In the early years, most of each payment goes to interest; in later years, most goes to principal. This is why a 30-year mortgage builds equity slowly at first. The exam may include amortization table questions or ask you to identify which component of PITI a given dollar amount represents.

Key Lending Laws for the Exam

• Truth in Lending Act (TILA) — Regulation Z: Requires lenders to disclose the annual percentage rate (APR) and total finance charges to borrowers. The APR reflects the true cost of borrowing, including interest and certain fees. TILA also gives borrowers a three-day right of rescission for certain refinance and home equity loans (but not purchase loans).
• Real Estate Settlement Procedures Act (RESPA): Requires lenders to provide a Loan Estimate within three business days of receiving a loan application, and a Closing Disclosure at least three business days before closing. RESPA also prohibits kickbacks and unearned fees in settlement services.
• Equal Credit Opportunity Act (ECOA): Prohibits discrimination in lending based on race, color, religion, national origin, sex, marital status, age, or receipt of public assistance. Lenders must provide reasons for credit denial.
• Usury Laws: State laws that set maximum allowable interest rates. Charging interest above the legal limit is usury. Rates and penalties vary significantly by state.

The Secondary Mortgage Market

When a lender originates a loan, they often sell it on the secondary market to free up capital for more lending. The three major secondary market players:

• Fannie Mae (Federal National Mortgage Association): A government-sponsored enterprise (GSE) that purchases conventional, FHA, and VA loans from lenders.
• Freddie Mac (Federal Home Loan Mortgage Corporation): Another GSE that performs a similar function, creating competition in the secondary market.
• Ginnie Mae (Government National Mortgage Association): A government-owned corporation that guarantees mortgage-backed securities backed by FHA and VA loans. Unlike Fannie and Freddie, Ginnie Mae does not purchase loans — it guarantees securities.

Foreclosure: What Happens When the Borrower Defaults

Foreclosure is the legal process by which a lender takes possession of and sells the property to satisfy the debt. The exam tests two types:

• Judicial Foreclosure: The lender files a lawsuit and obtains a court order to foreclose. The property is sold at a public auction supervised by the court. This process is slower but provides stronger legal protection for both parties. Used in lien theory states and required in some states regardless of theory.
• Non-Judicial Foreclosure: The lender follows a procedure outlined in the mortgage or deed of trust (typically including a "power of sale" clause) without court involvement. Faster and less expensive, but offers fewer borrower protections. Common in title theory states.

After foreclosure, if the sale proceeds are less than the debt owed, the lender may seek a deficiency judgment against the borrower for the remaining balance. Some states prohibit deficiency judgments on purchase-money mortgages. Many states also provide a statutory right of redemption, allowing the borrower to reclaim the property by paying the full debt within a specified period after the foreclosure sale.

Common Financing Exam Question Types

1. LTV calculations: "A buyer purchases a $250,000 home with a $200,000 loan. What is the LTV?" (Answer: 80%)
2. Discount point cost: "How much do 2.5 discount points cost on a $180,000 loan?" (Answer: $4,500)
3. PMI triggers: "At what LTV is PMI typically required on a conventional loan?" (Answer: above 80%)
4. PITI identification: "Which component of a mortgage payment covers hazard insurance?" (Answer: the second 'I' — Insurance)
5. Lending law application: "Which law requires the lender to provide a Closing Disclosure three days before closing?" (Answer: RESPA)
6. Foreclosure process: "In which type of foreclosure does the lender proceed without court involvement?" (Answer: non-judicial foreclosure)