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 an individual’s financial situation.
If you’re thinking about buying a home, then it’s crucial that you educate yourself about the basics of mortgage lending. We know the lingo can be a little confusing, so we’ve broken it down.
An appraisal essentially determines how much your house (or potential house), or property, is worth. Appraisals are assessed by third parties for a fee, which varies depending on the size of the property, but usually runs between $200 and $500. Appraisals are usually done when a home is sold, 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. The 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 figure as to how much you will pay.
Remember: use caution when comparing different loan types, like a fixed rate loan, to an adjustable rate loan. An adjustable rate loan assumes what interest rates may be in the future, while the interest on a fixed-rate loan wont change. (More on that later.)
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.
Adjustable Rate Mortgage (ARM)
Unlike a fixed rate loan, payments for an ARM can move up and down as the lender’s interest rate fluctuates. Most have an initial fixed-rate period during which your rate can’t change, followed by a longer period during which your rate can change at preset intervals.
For example, a 5/1 ARM is a typical product. This means that your rate won’t change for 5 years – during the introductory period. The “1” means that the interest rate can change every year after that.
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.” Caps are structured differently by lender and product, but are designed to limit the amount of change year-to-year or 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.
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 full loan be paid. 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, you must pay the loan in full – possibly by refinancing.
You may save money on payments, however, you risk having a significantly higher mortgage payment in the future if interest rates increase during the term of your balloon loan.
Closing costs are the fees that you’ll pay your lender during the final steps of getting a mortgage. The closing costs will be detailed in the Good Faith Estimate. These fees include loan origination fees, legal charges, taxes, title insurance, appraisal fees, and the cost of processing the loan. Closing costs usually range between 2 and 4% of the property price.
This ratio (DTI) is usually calculated when you submit a mortgage application. DTI is used to see how much of a burden your debt creates on your monthly budget. It is the percentage of the your gross income (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 going to make monthly debt payments. That includes home loans, car payments, minimum credit card payments, student loans and personal loans.
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 percent. 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.
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. The best rates and terms are often offered to borrowers who put more money down. (Plus if you put more money down, then you’ll likely own your home free and clear sooner!)
Good Faith Estimate
The Good Faith Estimate (GFE) 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 GFE within 3 days of a completed application.
Interest is the amount charged for borrowing funds and is usually expressed as a percentage. The interest rate is used to calculate your monthly mortgage payment based on the amount of time you will have to repay the loan.
The Loan-to-Value Ratio (LTV) is the ratio of the amount borrowed in comparison to the value of the home; LTV 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 percent down payment, your LTV will be 80 percent.
Title and Title Insurance
A title or deed is the legal document that proves you are the legal owners of a home. Title insurance is money paid to do a search of past ownership claims to a piece of property. It 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 speak up and ask questions.