10 Mortgage Terms You Should Know Before Applying for One
Whether you are a first-time home buyer or not, applying for a mortgage can be difficult. There are papers to gather, calls to make, plus a lot of things to try to keep track of. However, understanding the process and mortgage terminology makes for a much smoother transaction. Keep this list of 10 common mortgage terms handy, so you know the lingo as you start to consider a new home.
Amortization may be a big word, but the concept is simple. It means taking the loan and dividing it into payments. Next, those payments are spread out over time, usually in terms of months, to create a monthly payment. Included in the monthly payment are principal and interest (which we will talk about more later).
After each payment is made, the new total reflects the remaining balance owed to the bank. At the beginning of the loan, most of your payment will go towards interest. But over the years, as you continue making payments, more will go towards the principal of your loan.
Common types of amortized loans are mortgages and car loans, and you can find a number of amortization calculators online like this one that can help you visualize your amortization over the years.
Adjustable Rate Mortgage
An adjustable rate mortgage is sometimes called an ARM. It has an interest rate that adjusts throughout the life of the loan, with the interest rate being fixed for 1, 3, or 5 years.
After that time, the interest rate will go up or down depending on the financial index it is based on. This variable rate will cause your mortgage payment to change.
Adjustable interest rates can often be lower than fixed rates, but, despite the appealing rate, there can be drawbacks. Make sure you talk to your loan professional to see what those might be, and to decide if this mortgage is right for you.
Fixed Interest Rate
Just like it sounds, a fixed interest rate remains the same throughout the length of the loan. So, your payment (principal and interest) would be consistent year-after-year. When rates are low this type of loan is usually the best choice, because it ensures a lower, predictable monthly payment. For example, if you were able to get a fixed interest rate of 4.25% and in a few months interest rates rose to 5.25%, you still have a nice low rate.
When rates are high, however, fixed rate loans are not as appealing. In that case, borrowers may consider an adjustable rate loans with lower interest.
An important part of the home loan process is weighing your options. Be proactive and ask your loan officer any questions you have as it is also in their best interest to make sure you choose the best loan for your circumstances.
Loan-to-Value Ratio (LTV)
When you start the mortgage process, another common mortgage term you will hear is loan-to-value or LTV. This is the ratio of the home loan to the home value.
An easy way to look at it is if you looking to purchase a $400,000 home and you only needed to borrow $200,000 your LTV would be 50%.
The LTV is the standard calculation lenders base their underwriting decisions on because it helps them identify the amount of risk they are taking on to provide you with the loan. The lower the LTV, the lower the risk for the lender. The higher the ratio the higher risk for the lender. Lenders like lower risk loans, so a higher LTV could result in a higher interest rate.
A loan estimate is a disclosure from the mortgage lender that lists the costs associated with the loan. This straight-forward and easy to read document includes information about your interest rate, closing costs, and monthly payments. Once you have applied for a mortgage, your lender must give you this disclosure within 3 days.
While it might feel like a lot of information, having a mortgage loan estimate helps you in comparing mortgage offers from different companies, and picking the right loan for your situation.
Be informed and get the facts in writing. For more information about a loan estimate, visit the Consumer Financial Protection Bureau
There are two definitions of escrow you need to know when purchasing a home.
The first one is the escrow procedure, which outlines the process of the sales transaction. In this procedure, a trusted, neutral party like a title and escrow company or attorney handles the process to ensure the sales transaction is safe for both buyer and seller. In addition, these parties help to make sure all obligations are met and all legal documents are in order.
The other definition is for an escrow account. This account is set up with your lender. First, they estimate what your annual taxes and homeowner’s insurance will be. Then, each month they bill you for a portion of your taxes and insurance along with your principal and interest. That way, when taxes or insurance is due, the money is available. For example, if your mortgage payment is $1,409 each month, the split out is probably something like $1,012 for principal and interest, $330 for taxes, and $67 for insurance.
Bonus Tip: If you are a first-time home buyer, ask to have your taxes and insurance included in your loan payment. It will make your budgeting much easier.
Closing Disclosure/Settlement Statement
There are two documents a borrower receives at closing. One is a called a Closing Disclosure, and the other one is a Settlement Statement. These disclosures list all the funds received and paid including things like the escrow deposit amounts paid for property taxes, mortgage, and hazard insurance.
These documents also provide specific information about your mortgage loan, such as your monthly payments and any and all fees you are paying. Visit the Consumer Financial Protection Bureau for more information.
Mortgage Insurance Premium
MIP or mortgage insurance premium is insurance the borrower pays the lender if their down payment is less than the traditional 20 percent. This insurance protects the lender in the case of default and is treated like a premium that is added to the loan payment along with taxes and insurance.
While it may seem like an unnecessary insurance, this premium payment can help you to secure a loan and can be particularly helpful for first-time home buyers who may not have a 20 percent down payment. Your mortgage professional can tell you more about MIP.
Total Debt Ratio
Another important mortgage term is total debt ratio. This ratio is the calculation of debt and housing payments divided by gross monthly income and is used, like loan to value (LTV), by lenders to help determine risk.
The total debt ratio can also determine the type of loan you can get, as each loan type has specific rules on how high the debt ratio can be.
Generally, like we saw with the loan to value, the better the ratio you have, the better loan you can secure. So, having a higher income or lower debt can make you a better credit risk for the lender. But, even if your total debt ratio is too high, your mortgage professional can still help you. They will work with you to come up with a plan, so you can qualify for the home you want.
Bonus Tip: Sometimes you can lower your total debt ratio quickly by paying off purchases or loans. For example, if you have an auto loan of $500 a month and you only have eight payments left, paying it off early may make it possible to qualify for the loan amount you need by lowering your overall debt and improving your ratio.
Principal and Interest
The principal is the amount of money you borrowed for a home loan and it is the money that you will pay back to the lender by the end of the loan term. The interest is what the lender charges you to loan the money. As you pay your loan down, the principal owned to your lender reduces, but the interest payments will remain.
Principal and interest are most likely the largest part of your monthly payment but remember, your mortgage payment may also include taxes and insurance. The principle and interest will be shown separately and broken out from any taxes or insurance.
Applying for a mortgage is a big step in buying your next new home, but it doesn’t have to be frightening. While there are a lot of nuances to the process, familiarizing yourself with these 10 common terms or visiting other financing 101 sites can help take a lot of stress out of the process so you have more time to enjoy your new home.
Looking for more tips, ideas or inspiration? Return Home here.