One of the most important, and confusing, decisions that people make is buying a home and taking out a mortgage to pay for the house as there are many factors that come into play. Factors such as location, size of the house, and the overall costs can play important roles in the decision-making process. After finding a house, the decisions you make on your mortgage will have financial ramifications for years to come.
People in all businesses tend to speak their own ‘lingo’. A problem with that in the financial industry is that someone may be making the biggest economic decision of their lives and deserve to understand what’s going on with the process, and the correct meaning of every word, acronym, or phrase used, particularly in the Mortgage sub-sector.
Because knowledge is power, we have compiled the top mortgage vocabulary you should be familiar with that will clear up some of your confusion, as well as make purchasing a new home and discussing with your loan officer easier.
- Appraisal – an assessment of the value of your home (or home to be) based on the sale of similar size, design, and quality within a reasonable amount of distance. It is conducted by a professional appraiser who will look at a property and give an estimated value based on physical inspection and comparable houses that have been sold in recent times.
- Amortization – the amortization of the loan is a schedule on how the loan is intended to be repaid. For example, a typical amortization schedule for a 15-year loan will include the amount borrowed, the interest rate paid, and the term. The result will be a month breakdown of how much interest you pay and how much is paid on the amount borrowed.
- Annual Percentage Rate – is the rate of interest that will be paid back to the mortgage lender. The rate can either be a fixed or adjustable rate.
- Adjustable-Rate Mortgage – an adjustable-rate mortgage, known as an ARM, is a mortgage that has a fixed rate of interest for a specific or set amount of time or period, typically one, three, or five years. During the initial period, the interest rate is lower, and after that period it will adjust based on an index (often, the rate will fluctuate upwards and not downwards). The rate thereafter will adjust at set intervals.
- Closing Costs – Closing costs are ALL the costs involved in obtaining your mortgage with the sole exception of your down payment. These include the attorney’s fees, escrow account funding, recording fees, and other costs associated with the mortgage closing.
- Debt-to-income ratio – lenders look at a number of ratios and financial data to determine if the borrowers are able to repay the loan. One such ratio is the debt-to-income ratio. In this calculation, the lender compares the monthly payments, including the new mortgage, and compares it to monthly income. The income figure is divided into the expense figure, and the result is displayed as a percentage. The higher the percentage, the riskier the loan is for the lender. There are two types of DTI ratios; front-end and back-end. For both ratios, the lower the percentage, the better.
- Front-End Debt to Income Ratio: Divide your monthly housing expense (the total of your mortgage payment including taxes, insurance, mortgage insurance, and HOA if you have one) by your gross monthly income.
- Back-End Debt to Income Ratio: Combine your monthly housing expense with the required minimum payments of your other legally obligated monthly debts (car loans, credit cards, etc, but not food, or internet, etc) and divide that number by your gross monthly income.
- Down Payment – is the amount of the purchase price that the buyer is paying. Generally, lenders require a specific down payment in order to qualify for the mortgage.
- Equity – the difference between the value of the home and the mortgage loan is called equity. Over time, as the value of the home increases, and the amount of the loan decreases, the equity of the home generally increases.
- Escrow – at the closing of the mortgage, the borrowers are generally required to set aside a percentage of the yearly taxes to be held by the lender. On a monthly basis, the lender will also collect additional money to be used to pay the taxes on the home. This escrow account is maintained by the lender who is responsible for sending the tax bills on a regular basis. While not always required, an escrow account is a sort of savings account held by your lender that contains predetermined amounts of your homeowner’s insurance and taxes based on when each is due. Every month a portion of your total mortgage payment goes into the account so the lender can ensure your taxes and insurance will be paid in full when the time comes.
- Fixed-Rate Mortgage – is a mortgage where the interest rate and the term of the loan are negotiated and set for the life of the loan i.e. the rate and length of time you pay (term) do not change for the life of the loan. The terms of fixed-rate mortgages can range from 10 years to up to 40 years; 30-year fixed-rate mortgages are the most common.
- Good Faith Estimate – an estimate by the lender of the closing costs that are from the mortgage. It is not an exact amount; however, it is a way for lenders to inform buyers of what is needed from them at the time of closing of the loan.
- Homeowner’s Insurance – prior to the mortgage closing date, the homeowners will need to secure property insurance on the new home and the policy must list the lender as loss payee in the event of a fire or other event. This is usually in place prior to the loan going into effect.
- Loan-to-value Ratio – another typical financial calculation is called the Loan-to-Value (LTV) ratio. This calculation is done by dividing the amount of the mortgage by the value of the home. Lenders will generally require the LTV ratio to be at least 80% in order to qualify for a mortgage.
- Mortgage – is the loan and supporting documentation for the purchase of a home. Mortgage lenders generally follow strict underwriting guidelines to limit the possibility of borrowers defaulting on their payments.
- Origination Fee – when applying for a mortgage loan, borrowers are often required to pay an origination fee to the lender. This fee may include an application fee, appraisal fee, fees for all the follow-up work, and other costs associated with the loan.
- Points – are percentage points of the loan amount. Often in order to get a lower interest rate, lenders will allow borrowers to “buy down” the rate by paying points. Paying a percentage point upfront in order to get a lower rate will eventually be a saving to borrowers in the long run if they stay in the house for the duration of the loan. If they move shortly after buying the property then they will likely lose money buying points.
- Principal – is the term used to describe the amount of money that is borrowed for the mortgage. The principal amount that is owed will go down when borrowers make regular monthly or bi-weekly payments.
- Settlement Costs – prior to closing, the attorneys involved in the mortgage closing will meet to determine the final costs that are associated with the loan. These settlement costs are given to all parties so that they will be prepared to pay the closing costs that have been agreed upon.
- Title Insurance – the lender is using the home as collateral for the mortgage transaction. Because of this, they need to be certain that the title of the property is clear of any liens which could jeopardize the Mortgage. So, lenders will require borrowers to get title insurance on the property, which will ensure that the homes are free and clear.
- Truth in Lending – is a mandate that all lenders must follow. There are several important parts to the “Truth in Lending” regulations including proper disclosure of rates, how to advertise mortgage loans, and many other aspects of the lending process. These regulations were put in place to protect consumers from potential fraud.