Mortgage Basics: Understanding The Terminology Of Buying A Home

6/22/2021

Understanding mortgage terminology can make the homebuying process easier to navigate. Common terms such as APR, amortization, debt-to-income ratio, escrow, equity, PMI, principal, and closing costs describe important parts of borrowing and homeownership. Learning what these terms mean can help you compare mortgage options, understand the true cost of a loan, and know what to expect before and after closing. If you have questions about buying a home or managing a mortgage, a certified housing counselor can provide unbiased guidance to help you make informed decisions.

3 Key Takeaways

1. Understanding mortgage terminology helps you compare loans. Knowing the difference between terms such as interest rate and APR, or fixed-rate and adjustable-rate mortgages, can help you better evaluate your financing options.

2. Your mortgage payment is only part of the cost of homeownership. Down payments, closing costs, property taxes, homeowners insurance, PMI, and other expenses should all be considered when determining what you can afford.

3. Housing counseling can help you make informed decisions. HUD-approved housing counselors can provide unbiased guidance on homebuying, mortgage options, foreclosure prevention, reverse mortgages, and other housing needs.

Buying a home can be exciting, but the mortgage process can also feel like learning a new language. Between interest rates, escrow accounts, closing costs, points, mortgage insurance and loan estimates, there are a lot of unfamiliar terms to understand before you get the keys to your new home.

Understanding mortgage terminology can help you compare loan offers, ask better questions and make more informed decisions about one of the largest financial commitments you may ever make.

Here are some of the most important mortgage terms every homebuyer should know.

Adjustable-Rate Mortgage (ARM)

An adjustable-rate mortgage has an interest rate that can change over time. Many ARMs begin with a fixed interest rate for a specified period and then adjust periodically based on the terms of the loan.

For example, with a 5/6 ARM, the initial interest rate is generally fixed for five years and can then adjust every six months.

An ARM may initially offer a lower rate than a fixed-rate mortgage, but borrowers should understand how much the rate and monthly payment could increase in the future.

Amortization

Amortization is the process of gradually paying off your mortgage through scheduled payments.

With a typical fixed-rate mortgage, more of your payment goes toward interest during the early years of the loan. As the balance decreases, a larger portion of each payment goes toward reducing the principal.

Annual Percentage Rate (APR)

The APR is different from your mortgage interest rate. While the interest rate represents the cost of borrowing the principal, the APR incorporates the interest rate along with certain additional loan costs and fees.

Because of this, APR can be useful when comparing similar mortgage offers from different lenders. However, it is important to compare loans with similar terms and features.

Appraisal

An appraisal is a professional estimate of a property's value. Mortgage lenders generally require an appraisal to help determine whether the property provides sufficient collateral for the amount being borrowed.

The appraised value and the price you agreed to pay for the home are not necessarily the same.

Closing

Closing, sometimes called settlement, is the final stage of the homebuying transaction. This is when the required documents are signed, funds are transferred and ownership of the property is finalized.

Closing Costs

Closing costs are expenses associated with obtaining the mortgage and completing the real estate transaction. They can include lender fees, appraisal fees, title-related expenses, government recording charges, prepaid interest, initial escrow deposits and other costs.

Your closing costs are separate from your down payment. The amount you need to bring to closing is commonly referred to as your "cash to close."

Closing Disclosure

The Closing Disclosure provides the final details of your mortgage, including your loan terms, projected monthly payments, closing costs and cash needed to close.

For most mortgages, lenders are required to provide the Closing Disclosure at least three business days before closing. Compare it carefully with your most recent Loan Estimate and ask about anything that has changed or that you do not understand.

Debt-to-Income Ratio (DTI)

Your debt-to-income ratio compares your monthly debt obligations with your gross monthly income.

Lenders use DTI as one factor when evaluating whether you can reasonably manage a proposed mortgage payment along with your other debts.

A lender's willingness to approve a particular mortgage amount does not necessarily mean that amount will comfortably fit your household budget. Consider your other financial priorities and expenses when deciding how much home you can afford.

Deed

A deed is the legal document used to transfer ownership of real estate from one party to another.

The deed and title are related but are not the same thing. The deed is the document that transfers ownership, while title refers to your legal ownership rights in the property.

Down Payment

The down payment is the portion of the home's purchase price that you pay upfront rather than finance through your mortgage.

A 20% down payment is not required for every mortgage. Some conventional and government-backed loan programs allow qualified borrowers to purchase a home with considerably less money down.

A smaller down payment, however, may affect your monthly payment, mortgage insurance requirements and total borrowing costs.

Earnest Money

Earnest money is a deposit a buyer may make after a seller accepts an offer. It demonstrates the buyer's intention to complete the purchase.

What happens to the deposit if the transaction does not close depends on the purchase contract and applicable contingencies, so make sure you understand the terms before providing earnest money.

Equity

Home equity is the difference between the current value of your home and the amount you owe on loans secured by the property.

For example, if your home is worth $350,000 and you owe $250,000 on your mortgage, you have approximately $100,000 in equity.

Equity can increase as you pay down your mortgage or if your home's value rises. It can also decrease if property values fall or you borrow against the equity.

Escrow

An escrow account is an account your mortgage servicer may use to collect money for certain property-related expenses, most commonly property taxes and homeowners insurance.

A portion of these expenses is generally included with your monthly mortgage payment, and the servicer pays the bills when they become due.

Remember that some homeownership expenses, such as homeowners association fees, maintenance and repairs, may not be included in escrow.

FHA Loan

An FHA loan is a mortgage made by an FHA-approved lender and insured by the Federal Housing Administration.

FHA loans can make homeownership accessible to borrowers who may have smaller down payments or different credit circumstances than those typically associated with some conventional loans. FHA borrowers generally pay mortgage insurance premiums, commonly called MIP.

Fixed-Rate Mortgage

With a fixed-rate mortgage, the interest rate remains the same for the life of the loan.

That means the principal-and-interest portion of the mortgage payment remains predictable. However, your total monthly payment can still change if property taxes, homeowners insurance or other escrowed expenses change.

Homeowners Insurance

Homeowners insurance helps protect your home and belongings from certain covered losses and provides other protections depending on the policy.

Mortgage lenders generally require borrowers to maintain homeowners insurance. The premium may be included in your monthly payment through an escrow account.

Interest Rate

The mortgage interest rate is the percentage a lender charges for borrowing money.

Even a relatively small difference in interest rates can affect your monthly payment and the total amount of interest you pay over the life of a mortgage, which is why comparing multiple loan offers can be worthwhile.

Loan Estimate

After you apply for a mortgage, the lender generally must provide you with a Loan Estimate within three business days.

This standardized document provides important information about the proposed mortgage, including the interest rate, estimated monthly payment, closing costs, mortgage insurance and estimated cash needed to close.

Loan Estimates can make it easier to compare offers from different lenders.

Loan-to-Value Ratio (LTV)

Loan-to-value ratio compares the amount of your mortgage with the value of the property.

If you purchase a $300,000 home with a $30,000 down payment and borrow $270,000, your initial LTV would be 90%.

LTV can affect loan eligibility, interest rates and mortgage insurance requirements.

Mortgage Insurance

Mortgage insurance generally protects the lender, not the homeowner, if the borrower is unable to repay the mortgage.

With many conventional mortgages, private mortgage insurance, or PMI, may be required when the borrower makes a down payment of less than 20%.

Government-backed mortgages may have different mortgage insurance or funding fee requirements. FHA loans, for example, generally require mortgage insurance premiums.

Mortgage Points

Mortgage points, sometimes called discount points, are upfront fees you can pay to a lender in exchange for a lower interest rate.

One point equals 1% of the mortgage amount. On a $300,000 mortgage, one point would cost $3,000.

Whether purchasing points makes financial sense depends partly on how much they reduce your interest rate and how long you expect to keep the mortgage.

Preapproval

A mortgage preapproval is a lender's preliminary assessment of how much you may be qualified to borrow based on financial information you provide and the lender verifies.

A preapproval can help establish a realistic home-shopping budget and show sellers that you have taken steps toward obtaining financing.

However, preapproval is not a guarantee that the lender will ultimately approve the mortgage.

Principal and Interest

Principal is the amount you borrow. Interest is what the lender charges you for borrowing that money.

Together, principal and interest generally make up the largest portion of your mortgage payment, but they may not represent your entire monthly housing payment.

Property taxes, homeowners insurance, mortgage insurance and other expenses may also need to be considered.

Private Mortgage Insurance (PMI)

PMI is a type of mortgage insurance that may be required on a conventional mortgage when the borrower has less than a certain amount of equity in the property, often because the down payment is less than 20%.

PMI protects the lender rather than the borrower. Depending on the loan and applicable requirements, borrowers may eventually be able to have PMI removed after building sufficient equity.

Rate Lock

Mortgage rates can change while you are going through the homebuying process. A rate lock is an agreement from a lender to hold a specific interest rate for a defined period, assuming the conditions of the agreement are met.

Ask your lender how long the rate is locked, whether there is a fee and what happens if your closing is delayed.

Rate Buydown

A rate buydown reduces the mortgage interest rate, either temporarily or for the life of the loan.

With a permanent buydown, the borrower typically pays discount points upfront to obtain a lower interest rate.

Temporary buydowns, which may sometimes be funded by a seller or builder, reduce the borrower's payment during the first year or several years before it increases to the full contractual payment.

Make sure you understand what your payment will eventually become rather than evaluating affordability based only on the introductory payment.

Title and Title Insurance

Title refers to the legal ownership rights associated with a property. A title search reviews public records for ownership issues, liens or other claims involving the property.

Title insurance provides protection against certain covered title problems. Lender's title insurance protects the mortgage lender, while owner's title insurance is designed to protect the homeowner's financial interest.

Underwriting

Underwriting is the lender's process of reviewing your finances and the property before approving the mortgage.

An underwriter may examine your income, employment, assets, debts, credit history and information about the property. You may be asked for additional documentation during this process.

VA Loan

VA loans are mortgages offered by private lenders and backed by the U.S. Department of Veterans Affairs for eligible veterans, service members and certain surviving spouses.

Qualified borrowers may be able to purchase a home without a down payment or monthly private mortgage insurance, although other requirements and costs, such as a VA funding fee for some borrowers, may apply.

Your Mortgage Payment Is Only Part of the Cost of Owning a Home

One of the most important concepts for prospective homebuyers to understand is that the mortgage payment is not the same thing as the total cost of homeownership.

In addition to principal and interest, homeowners may need to budget for:

• Property taxes
• Homeowners insurance
• Mortgage insurance
• Homeowners association fees
• Utilities
• Maintenance and repairs
• Major replacements such as a roof, HVAC system or appliances

When deciding how much home you can afford, look beyond the amount a lender is willing to approve. Consider how the complete cost of owning the home fits into your monthly budget and your other financial goals.

Knowledge Can Make the Homebuying Process Less Overwhelming

You do not need to become a mortgage expert before buying a home, but understanding the terminology can make it easier to evaluate your options and recognize the questions you need to ask.

Pre-purchase housing counseling can also help prospective homebuyers understand the financial responsibilities of homeownership, prepare a realistic budget, review credit and debt, and better understand the mortgage process before making a commitment.

A HUD-certified housing counselor can provide personalized guidance and help you prepare for homeownership with greater confidence.

The more you understand before you sign, the better prepared you can be for both buying and owning your home.

 

 

 

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