Mortgage Terms Explained
Buying a home is one of the biggest financial choices most of us will make. Unfortunately, not all mortgage lenders take the time to ensure potential borrowers understand how the process works, the different types of loans available, and which products are the right match for each person's financial situation.
If you're thinking about buying a home, then it's crucial to educate yourself about mortgage terminology and mortgage vocabulary.We know the lingo can be a little confusing, so we've broken it down.
Adjustable Rate Mortgage (ARM)
Unlike a fixed rate loan, payments for an ARM can move up and down as the index rate fluctuates during the life of the loan. Most ARMs have an initial fixed-rate period during which your rate can't change, followed by a longer period during which your rate can change during the remaining years on the loan.
For example, a 5/1 ARM is a typical product. This means that your interest rate won't change for the first 5 years, which in this case is the introductory period. The "1" means that the interest rate can change every year after, which is after the introductory period ends.
Why get an ARM?
Generally, the initial rate is lower than a fixed rate, BUT since you can't predict future rates, you won't know for certain what you'll be paying in the future. ARMs do come with "caps" to prevent your interest rate from changing drastically. Caps are structured differently by lender and are designed to limit the amount of change year-to-year and over the life of the loan.
If you're interested in an ARM, make sure you understand how they work AND the maximum amount that you could end up paying after the introductory period is over. BankRate.com offers a helpful article that explains how ARMs work more thoroughly.
Amortization, or Amortized
Amortization refers to spreading loan payments in equal amounts over a set amount of time. For example, if a loan's amortization period is 20 years, then your loan payment would be the same amount each month for 20 years.
Appraisal
A real estate appraisal essentially determines how much a house or property is worth. Appraisals are assessed by third parties for a fee, which varies depending on the size and type of the property, but typically runs somewhere between $800 and $1,000 or more. Price is determined by the size of the property and type of structure as well as location. Appraisals are usually done when a home is sold, if you want to open a home equity line of credit, or if you're trying to refinance your existing home loan.
APR (Annual Percentage Rate)
The APR is typically more accurate than the interest rate when comparing loans. APR calculates the yearly finance cost of the mortgage in the form of a percentage rate. Unlike the interest rate on a loan, the APR takes into account the fees and points you pay to the lender, giving you a more complete picture of what you'll end up paying.
Remember: use caution when comparing different loan types, like a fixed rate loan to an adjustable rate loan. The interest rate on an adjustable rate loan can change and go up or down, while the interest rate on a fixed-rate loan won't change. More on that later!
Balloon Loan
Some mortgages allow you to make interest-only, or near interest-only, payments for a period of time, usually 3 or 7 years, before requiring that the loan be paid in full. With a balloon loan, your monthly payment may be calculated based on paying the loan back (amortized) over 30 years, but at the end of the balloon term (say 3 or 7 years), you must pay the remaining amount of the loan in full—possibly by refinancing.
You may save money by having lower payments at first, but you risk having a significantly higher mortgage payment in the future if interest rates increase during the term of your balloon loan.
Closing Costs
Closing costs are the fees that you'll pay your lender and/or third parties during the final steps of getting a mortgage. The closing costs will be detailed in the Loan Estimate. These fees include loan origination fees, legal charges, taxes, title insurance, appraisal fees, credit report and the cost of processing the loan. Closing costs usually range between 3-6% of the property price.
Closing Disclosure
A multi-page document provided to you at least three days before closing of the home purchase. This provides final details about the mortgage loan you've selected. It includes the loan terms, your projected monthly payments, and how much you'll pay in fees and other costs to get your mortgage, also known as closing costs.
Debt-to-Income Ratio (DTI)
This ratio (DTI) is usually calculated when you submit a mortgage application. DTI is used to see the total amount of debt payments you make compared to how much you earn. It is the percentage of your gross income (paycheck amount before taxes and other deductions come out) that's devoted to paying off debt each month. Most lenders will want no more than 36 to 42% of your gross income to go toward monthly debt payments. That includes home loans, car payments, minimum credit card payments, student loans, and personal loans.
Discount Points
Discount points are the amount you pay in exchange for a lower interest rate. Discount points, like loan origination fees, are expressed as a percentage, such as 1.5%. That percentage is applied to your loan amount to determine the dollar cost of obtaining a discounted rate.
Investopedia explains it like this:Each discount point generally costs 1% of the total loan amount and, depending on the borrower, each point lowers the loan's interest rate by one-eighth to one-quarter of a percent. Discount points are tax deductible only for the year in which they were paid.
Down Payment
The down payment is the amount of cash you put toward purchasing your home. It is subtracted from the sales price when calculating the total amount that will be borrowed or financed. Lenders usually want at least 10 percent down, but depending on the type of mortgage you choose you may be able to put down a lower percentage. The best rates and terms are often offered to borrowers who put more money down. Plus, if you do put more money down, you can save money each month with a lower monthly payment, and, generally speaking, pay less in interest.
Escrow
A contractual arrangement in which a third party receives and disburses money or documents for the primary transacting parties (seller, buyer, lender) or, a trust account held in the borrower's name to pay obligations like property taxes and insurance premiums. After an initial deposit, borrowers pay into the escrow monthly, usually as part of the mortgage payment. The Lender/Servicer pays the property taxes and insurance premiums on behalf of the borrower.
Good Faith Estimate/Loan Estimate
The Loan Estimate (LE) is an estimate of closing costs, such as fees charged by the lender, and the necessary expenses to acquire a home loan. Your lender is required to supply you with your LE within 3 days of a completed application.
Intent to Proceed
A consumer must indicate to the lender or broker their intent to proceed (willingness to proceed with the loan transaction). The consumer can communicate in any manner that they wish to proceed after the Loan Estimate has been delivered.
Interest/Interest Rate
Interest is the amount charged for borrowing funds and is expressed as an annual percentage of the amount of the loan. The interest rate is used to calculate your monthly mortgage payment based on the amount of time you have to repay the loan.
Loan-to-Value Ratio
The Loan-to-Value Ratio (LTV) is the ratio of the amount borrowed in comparison to the value of the home. This ratio is expressed as a percentage. The higher your down payment (or your equity in the home if you're refinancing), the lower your LTV. For example, if you are purchasing a home and make a 20% down payment, your LTV will be 80%.
Mortgage Broker
An individual or company who connects borrowers and lenders for the purpose of facilitating a mortgage loan. Unlike a mortgage lender, a broker does not make the loan or service the mortgage. A mortgage broker may represent various lenders or may offer loans from one single source
Points
Borrowers can pay a lender points to reduce the interest rate on the loan, resulting in a lower monthly payment. The cost of one point is equal to 1 percent of the loan amount. Depending on the borrower, each point lowers your interest rate by one-eighth to one one-quarter of a percent. Contact your lender to learn more about how this works.
Title and Title Insurance
A title or deed is the legal document that proves you are the legal owner of a home. Title insurance is a policy to protect home buyers and mortgage lenders from damage or financial losses caused by or due to title defects. A fee is paid to do a search of past ownership claims to a piece of property and protects a buyer should someone come forward to make a claim to the property (usually because of unpaid taxes or property disputes).
By understanding the most common mortgage terminology, you can eliminate confusion in the home buying process AND help ensure that you're in the right mortgage for your situation.
A home loan is the largest investment you will make, so be sure to ask as many questions as you need to fully understand everything!
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