You’ve found your dream home, which means it’s time to start the mortgage process. If you find yourself overwhelmed and confused by all the mortgage terms out there, don’t worry because you’re not alone. Getting a mortgage can be a complicated process, made worse by all the unfamiliar terminology your mortgage lender might use.
For many it can seem like a foreign language, and creates many questions about mortgage terms. Never fear, this quick primer will help you understand some of the mortgage terms that you might encounter and what role they play in the mortgage process.
Mortgage Term 1: Private Mortgage Insurance (PMI)
If you have a down payment of less than 20%, your lender might require private mortgage insurance (PMI). PMI is insurance that offers protection to your lender if you fail to make your monthly mortgage payments and default on the loan. If your mortgage comes with PMI, then you should be able to have it removed once your loan-to-value ratio (see the next paragraph) reaches a certain level. The level typically needed to have PMI removed is 78% of your home’s value.
Loan-to-Value (LTV) Ratio
The LTV is a ratio that divides the amount of money you’re borrowing for the home by the total value of the property. The larger your down payment, the lower your loan-to-value ratio is. When originating a mortgage or refinancing, lower loan-to-value ratios—80% and below—usually mean more favorable interest rates for you, the buyer.
|Total Property Value||Loan Amount||LTV Ratio|
Lenders use LTV to assess their risk on extending you a mortgage. Higher LTVs indicate a higher risk of default. That risk is based on the loan being for nearly as much as the value of the property, so there is little, if any, equity for you, the lender to fall back on in case of foreclosure.
Adjustable Rate Mortgage (ARM)
An adjustable rate mortgage is a mortgage product that uses a fixed rate for a certain loan term—typically 3, 5, 7 or 10 years. The interest rate on an ARM is usually lower than the rate you receive on a fixed-rate mortgage, also known as a conventional mortgage. However, once the fixed period of an ARM loan term is over, the rate variably adjusts up or down, depending on current interest rates.
A conventional fixed-rate mortgage of one of the more popular products for home buyers. It takes any uncertainty out of your loan. The rate for a fixed-rate loan stays the same until you either pay off the loan or refinance it. If your rate is 4.125% the day you close the loan, it will stay at 4.125% until you pay the loan off or refinance for a different rate.
The downside of fixed-rate mortgages is that they tend to come with higher interest rates than adjustable-rate mortgages. Plus, you won’t be able to take advantage of interest-rate declines. A fixed-rate mortgage, however, does offer you protection against rising interest rates.
A jumbo loan is a mortgage for an amount greater than the limits set by the Federal Housing Finance Agency (FHFA). These limits are referred to as the maximum conforming loan limits and change annually. They set limits on the amount a mortgage can’t go above and still be purchased by Fannie Mae (the Federal National Mortgage Association) or Freddie Mac (a government-owned corporation that buys mortgages and turns them into mortgage-backed securities). In most areas of the U.S., jumbo loans apply to luxury properties. In 2019, values can’t exceed $726,525 or 150% of the limit of $484,350.
Federal Housing Administration (FHA) Loan
FHA loans let borrowers purchase a home with a lower down payment than a conventional loan. They are also available for lower interest rates than conventional fixed-mortgage loans. FHA loans are insured by the Federal Housing Administration, which is part of the Department of Housing and Urban Development. With an FHA loan, there’s more flexibility in the borrower’s credit score, and borrowers can have scores at low as 500. FHA loans, however, do typically require mortgage insurance with an upfront premium and annual premiums.
Annual Percentage Rate (APR)
The annual percentage rate (APR) is the rate you’re charged to borrow the money for your mortgage loan. APRs are shown as percentages. That percentage is the amount you pay on top of the loan amount for borrowing the funds. It includes your interest rate, finance charges and fees, so it is higher than the interest rate itself. For example, if your loan is 400,000 at an interest rate of 4.125%, your APR might be 4.157% for 30 years. You would pay 697,895.22 for the 400,000 loan. The APR is where the added 297,895.22 comes from. It’s the cost you’re charged to borrow the money.
The federal Truth in Lending Act requires all lenders to tell the potential borrower what the APR is. Because fees and finance charges vary by lender, APRs can vary by lender as well, even for the same interest rate.
Discount points or mortgage points are fees you can pay at closing to reduce the interest rate on your mortgage. It is also known as buying down the rate. The more points you purchase, the lower your interest rate will be. Points typically cost 1% of the loan amount. That means if you purchase a $300,000 home, one point will cost $3,000. You’re basically prepaying interest at the time you get the loan by buying points.
Here’s a quick illustration of how discount points can help your long-term cost of buying a home with a 400,000 mortgage.
|0 Points||1 Point||2 Points|
|Cost of Point(s)||$0||$4,000||$8,000|
|Savings on 30-Year Loan||$0||$21,233||$42,149|
Good Faith Estimate (GFE)
Within three days of submitting a home loan application to a lender, the lender has to give you a good faith estimate (GFE). The term GFE was replaced by the current term, the Loan Estimate and Closing Disclosure Form, in October 2015. The GFE details exactly what the closing costs will be on your loan, including fees, title charges and more. Getting a GFE from a lender doesn’t obligate you to take that lender’s loan.
The servicer is the one that sends mortgage statements, collects loan payments and distributes payment for items such as insurance and property taxes. While you might receive your loan from one company, a different company might be the one that services the loan.
Principal, Interest, Taxes and Insurance (PITI)
When you hear the term PITI, it’s referring to your total monthly mortgage payment, which can include loan principal, loan interest, property taxes, homeowners insurance and/or mortgage insurance (PMI).
After you submit your application for a home loan, it goes to the underwriting department. This department ensures it has all necessary documents to complete your loan. It then assesses your application, how risky you are to loan money to and whether or not to approve your loan. It considers your credit score, assets, employment and other factors when making its decision.
These are fees charged by the lender to cover their costs to process your loan. Most lenders charge an origination fee of .5% to 1% of the total loan value.
As you consider different lenders and negotiate terms, interest rates can fluctuate based on market conditions. Once you choose a lender and agree with its terms, you want to lock in your interest rate. This is known as a mortgage rate lock. It ensures your rate won’t go up between the time you lock it in and you close, which usually takes four to six weeks. The potential downside is that the interest rate may go down and you’ll be locked in to a higher rate.
Part of your monthly mortgage payment goes to paying real estate taxes and insurance. This money is typically placed into an escrow account and then distributed on a set schedule. Zillow defines escrow as “when an impartial third party holds on to something of value during a transaction.” Throughout the mortgage process, different transactions at different times are held by a third party. For example, your earnest money, which is a deposit that tells the seller that you intend to buy the home, doesn’t go to the seller, but is held by a third party until you close on the house. If you don’t, it goes back to you.
Escrow also comes into play with your lender, who pay your PITI expenses from your monthly mortgage payment. The lenders holds those funds in escrow and makes the payments for you.
Escrow can happen as closing as well. An escrow officer will give out all the needed funds to the different parties to ensure your mortgage closes and you get the key to your new home.
This term refers to the process of spreading out a loan into equal monthly payments for a term, such as 15 or 30 years for a mortgage. The payment includes both the interest and principal as well as other costs potentially. The actual interest and principal paid each month changes as more money goes to the principal over time. However, your monthly payment stays the same.
For example, for a sample loan with a starting balance of $20,000 at 4% interest, the monthly payment is $368.33. The principal accounts for $301.66 of that, the interest accounts for $66.67 and the balance after your first payment totals $19,698.34. For your thirteenth payment, $313.95 goes to the principal and $54.38 goes to interest.
The shifts or amortization happen behind the scenes—although you should be given an amortization schedule by your lender, so you can see the shifts. Your very last payment will likely be less than your monthly payments and will pay off the remaining balance of the loan.
If you fail to make payments on this type of loan, you see an increase in the principal balance of the loan, which is known negative amortization. The loan payment shouldn’t be less than the interest charged for that particular period. To avoid fees and higher interest, you want to avoid negative amortization.
Balloon mortgages don’t fully amortize over the term of the loan. Instead, they have a balance the date the loan matures—the date of the final payment. That balance is large and is for the principal only. Interest will have been paid out of the monthly payments. The final payment of the loan is a balloon payment. Having this type of mortgage loan is more common in commercial real estate than in residential real estate.
Debt-to-Income Ratio (DTR)
Debt-to-income ratio (DTR) is used by lenders to assess risk. Your ratio is your total debt divided by your income. If you have a higher debt-to-income ratio, it’s harder to get approved for a loan, because a mortgage lender will see you as a risk. In most cases, a 43% debt-to-income ratio is the highest a mortgage lender will consider before approving a mortgage application. However, the ideal percentage for your DTR should fall under 28% on the front-end, which is how much of your gross income goes to housing costs, and no more than 36% on the back end, which includes all of your monthly expense. The generally term, DTR, usually encompasses the back end where front-end DTR is considered a variation of the standard DTR.
You can calculate your debt-to-income ratio with the Credit.com Debt-to-Income (DTI) Calculator.
Truth in Lending Act (TILA)
To protect consumers from inaccurate and unfair credit billing and practices, the Truth in Lending Act (TILA) was created. The federal law passed in 1968 to ensure that lenders treat consumers fairly in the lending marketplace. It includes the requirement of disclosures regarding terms and costs and an explanation to how these costs associate with the borrowing process and how they get calculated.
Knowing these terms can make the mortgage process much easier and more transparent for the borrower. Securing a mortgage loan is one of the biggest transactions a person can make in their lifetime which makes it all the more important to understand the process from beginning to end to give you the confidence you need when signing the papers for your new home.
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