First-time buyers of big things – namely, houses – often try to avoid showing up to meetings unprepared and, second only to the fear of making an enormous financial commitment, worry about not being taken seriously. Whether you’re about to meet with a realtor or lender, or just want to research the internet with a stronger base of understanding, I’ve compiled the most important and most common mortgage terms to help you navigate the housing market like a professional (or seasoned buyer).
Once you’ve got these terms down pat, get a more comprehensive overview and analysis with this U.S. Residential Mortgage Business class.
Adjustable Rate Mortgage (ARM)
An ARM is a loan with a variable interest rate. The rate changes over time in response to a standard financial index. There are tradeoffs to working with an adjustable rate mortgage. At first, the interest rate on an ARM starts out lower than a fixed-rate mortgage (more on that soon, but you can guess the fundamental difference). This initial rate is locked in place for a predetermined period of time, usually at least one year and often more. Of course, once this time period expires, the interest rate starts to go up. You will be happy to hear that there are limits (again, predetermined) at how high the rate can rise. The benefit of this is having a lower payment at the beginning of the mortgage.
Learn about the different types of loans and their features with this class on understanding loans.
If your monthly payment is $500 and $250 is devoted to interest, than the other $250 would be your amortization. In other words, it’s the amount of your monthly payment that actually goes towards paying off the principle. Mathematically: Payment – Interest = Amortization.
Annual Percentage Rate (APR)
How many times have you heard APR on commercials? APR is an annual calculation that combines several costs into one figure. These include interest rate, origination fees, mortgage insurance, etc. Needless to say, APR is a higher figure than just a standard interest rate.
Pick up some some other financing tips with this free article by finance expert Jean Chatzky.
The document produced by an appraiser that outlines an estimate of a property value.
Closing costs are important for all home buyers. When you “close” on a house, you effectively and officially take over ownership of the property. Closing costs are expenses related to this process, including taxes, attorney fees, title insurance, etc. Word to the wise: lenders are supposed to provide accurate estimates of these costs from the outset.
Down payments are the amount of the purchase price paid, in “cash,” by the buyer. If you are buying a house for $100,000 with a 10% down payment, then you will pay $10,000 up front while taking out a $90,000 mortgage. Common down payment percentages range from 5-20, although depending on your qualifications and a certain lender’s policies, it would be possible to find a zero-down mortgage. Generally speaking, the more you put down, the lower your mortgage payment is going to be.
An escrow is basically a trusted third party account holder. They keep all money and documents in safe keeping until the sale is finalized. An escrow is also used to hold property taxes and insurance monies that are part of each mortgage payment.
As opposed to an adjustable rate mortgage, a fixed-rate mortgage is one in which the interest rate is consistent for the duration of the agreement, whether this is ten or thirty years. While these typically have higher initial payments than adjustable rate mortgages, the benefit is that the holder of the mortgage knows exactly how much each monthly payment is going to be. In other words, no surprises.
Good-Faith Estimate (GFE)
As mentioned in Closing Costs, a GFE is a detailed estimate of closing costs. The lender is required by law to provide accurate information (or as accurately as possible given the circumstances) to prospective buyers.
Interest-Only (IO) Loans
This is a form of, usually, an adjustable rate mortgage in which only the interest is paid (that is, without the principle) for a predetermined period of time. IO loans should be heavily researched before committing to one, as they generally involve an element of risk. People who do not apply for regular (fully amortized) mortgages can qualify for IOs. The usual assumption is that that person’s income is going to increase soon and/or dramatically. An IO would make sense for someone who doesn’t want to waste money on fees and moving costs for a starter house and wants to use an IO to get a mortgage on what would otherwise be a “second” house.
There are other types of risky loans and mortgages out there. Read this blog post on the disadvantages of reverse mortgages for more information.
Even though everyone knows what an interest rate is (the rate charged each period to the borrower), it still helps to understand how they work. Interest rates are expressed annually, so if your rate is 6% and you make monthly payments, your monthly interest rate is 0.5%. This will come as a relief to anyone thinking they had to pay 6% per month.
I might also recommend this class on the principles of simple interest, which will help you understand all the different scenarios you will face.
Loan To Value Ratio (LVR)
This is simply the ratio of a home’s value and the amount being mortgaged. LVR really only becomes important when it exceeds 80%, which requires the buyer to purchase private mortgage insurance (PMI). For example, if a home is sold for $200,000 and the mortgage is anything greater than $160,000 (an LVR of 80%), then PMI is needed.
Points are factored into a loan’s APR (1 point = 1% of the loan). You can use discount points to reduce your interest rate. So if you want to lower your interest by one point, you have to cough up one point of the mortgage. For example, on a $500,000 mortgage, you would have to pay an additional $5,000 at closing per point.
This is the total amount of money borrowed from the lender. Every payment, with the exception of IO loans, causes the principle to go down.
Private Mortgage Insurance (PMI)
As mentioned earlier, PMI is required for down payments that equal less than 20% of the cost of the home. These insurance policies protect the lender from the borrower defaulting on the loan. Please keep in mind that PMI payments should cease once the borrower has reached the 20% mark. This course on mortgage fraud and protection provides other ways to safe-guard yourself against potential mortgage pitfalls.
Title insurance is a policy that protects the owner’s rights to the property (this includes the right to ownership, the right to transfer the title, etc.). If some long-lost great-nephew of the person who owned the house 200 years ago tried to make a legal argument that the house was technically his, the title insurance would pay for legal damages.
This is a hybrid between a fixed rate mortgage and an adjustable rate mortgage. In a two-step mortgage, there is an initial period with a fixed rate, followed by a second period in which the rate is adjusted once for the remainder of the loan. They commonly go by names that split the years of the loan term into a fraction: 2/28, 5/25, etc. A 5/25 mortgage means that one rate applied to the first five years, and then another rate applies to the last twenty-five years.
If you think you’re ready to finance your first home, do yourself a favor you won’t regret and check out this investing and personal financial management course to help you plan for lasting financial commitments.