Mortgages 101 - A Guide to Understanding Basic Mortgage Terms
You’re sitting across from your real estate agent, Michelle. She is suddenly using unfamiliar words and acronyms like “escrow,” “amortization,” “PMI,” “LTV,” “debt-to-income ratio,” and “earnest money,” and you’re starting to feel a little like she hates you. If she didn’t hate you, why would she be talking to you like this? Using all this deeply mystifying language that makes you feel like a fool?
Don’t worry. Michelle doesn’t hate you. She’s just talking about your mortgage.
For better or worse, the mortgage industry has its own lingo, with terms you’re unlikely to hear outside homebuying or refinancing. This lingo can seem pretty confusing for laymen like you and me. For first-time homebuyers, it can feel utterly incomprehensible. So take a deep breath, and rest assured that Michelle is only trying to help. And, before your next meeting with her, check out our plain-English guide to understanding basic mortgage terms.
Wait, Do I REALLY Need to Understand All These Terms?
You want to get the mortgage that’s best for your lifestyle, budget, and future plans, right? A mortgage that you can genuinely live with for the next 15 to 30 years? That’s why it’s important to go into the mortgage process with at least a basic understanding of typical mortgage terms. If you don’t, you could end up signing up for a mortgage that won’t work for you, or fees you can’t afford.
So yeah. You pretty much do. That said, Michelle — or the mortgage lenders you’ll end up talking with — should be able to explain anything you’re confused about. And so we forge bravely onward, helping you know what they’re all talking about and why it matters. Welcome to Mortgages 101, getting you several steps closer to understanding basic mortgage terms.
Glossary of Basic Mortgage Terms (That Hopefully Won’t Put You to Sleep)
Adjustable-rate mortgage, or ARM. When Michelle says “ARM,” she is not referring to the upper-body appendage also known by this name. She’s referring to a home mortgage loan with interest rates that may change over time. Federal interest rates fluctuate based on what’s happening in the US economy. Lucky for you, however, ARM interest rates are usually capped, making sure things can’t get too crazy.
Amortization. This is a fancy word for your mortgage loan repayment schedule. Depending on your interest rate and term (typically 15 or 30 years), you’ll pay a certain amount of money toward principal and interest each month. Amortization gives the monthly breakdown of how much you’ll pay toward each.
Annual percentage rate, or APR. Essentially the cost of borrowing money, this percentage expresses the annual cost of your mortgage to you. It includes what you’re paying for interest, PMI, and any other fees, and it will always be higher than the interest rate quoted alongside it. Paying attention to APR helps you compare the costs of mortgages from different lenders.
Appraisal. Mortgage lenders generally require a home appraisal, which is an assessment of a home’s current market value performed by a qualified professional. The appraisal helps determine how large of a mortgage loan you’ll need to buy the home.
Balloon payment. This is a big final loan payment. Certain mortgage loans require a large final payment (separate from the monthly payments) at the end of your mortgage term.
Closing costs. Buyers, sellers, and lenders pay several fees and costs that are required to “close on” a mortgage deal. Also known as “settlement costs,” these costs are spelled out in your mortgage contract and disclosures. They may include things like escrow fees, title insurance, recording fees, transfer taxes, realtor commissions, and mortgage lender charges (e.g., origination fee). First-time homebuyers, ask your realtor to spell out your likely closing costs early in the process, so you know what to expect.
Conventional loans. The US government insures many loans made by banks and other mortgage lenders (see “FHA loans”). Conventional loans are mortgage loans that are NOT government-insured. These loans are considered higher-risk, thus requiring higher down payments.
Debt-to-income ratio. This describes the percentage of your monthly income that goes toward repaying debt. By comparing total monthly income with total monthly debt payments, lenders assess your ability to repay your mortgage. The lower the ratio, the less risky a bet you appear. (Calculate yours.)
Deed. This refers to the physical legal document that transfers ownership of your home. (See also “title.”)
Discount points. See “points.”
Earnest money. Are you serious about buying that house? When a seller accepts your offer and a contract or purchase agreement is signed, you pay a good-faith deposit to the home’s seller to show that you’re, you know, EARNEST. Earnest money is typically held in escrow (see below) until closing. It may or may not be refundable, depending on the terms of your contract or agreement.
Equity. This is your home’s current market value minus what you still owe for it. As you pay off more of your mortgage, you own more of your home, increasing your equity. Equity can also be increased by home improvements or market changes (e.g., equity is likely to increase in an in-demand market).
Escrow. This weird-sounding word — which many first-time homebuyers don’t really understand — can have two meanings in the mortgage process. In a home sale, escrow refers to the special account that holds all money involved in the property transfer until the sale is complete. Once you own the home, it refers to the special account that holds money in reserve for your homeowners insurance and property taxes. Basically, you pay money into this account as part of your regular monthly payments. Then, when the time comes, your lender pays these bills on your behalf.
FHA loan. Easy-peasy: FHA loans are simply mortgage loans insured by the FHA. (See also “conventional loans.”)
Fixed-rate mortgage. This is a home mortgage loan with an interest rate that will remain unchanged throughout the term of the loan. So, no matter what happens to the economy, your rate won’t go up. That said, if rates go down, you DO have the option to refinance your mortgage at a lower interest rate.
Foreclosure. If you don’t make your monthly mortgage payments, you give up the rights to your home. Foreclosure happens when your mortgage lender seizes and sells your home to recover their loss.
Homeowners insurance. Oh, hold up! If you’re already hanging out here at Covered, you may know this one! In a mortgage context, homeowners insurance helps ensure that your home won’t be a financial loss for your lender in the event of damage or loss. Lenders require its purchase prior to closing.
Joint loan. No, this has nothing to do with the burgeoning market for legalized marijuana. A joint loan is simply a mortgage loan signed by two co-borrowers who are equally responsible for repaying the loan.
Lien. This is a security interest in a piece of property. If you live in a “lien theory” state, your mortgage lender attaches a lien to your home until you pay off your mortgage in its entirety.
Loan estimate form. Before signing a mortgage, you want to understand the total costs you’re likely to incur in obtaining your loan. Formerly known as a “good faith estimate,” this written estimate required by the Truth in Lending Act represents a lender’s best guess of those costs. Required within three days of a loan application, this form — like the APR — helps you compare mortgages from different lenders. (First-time homebuyers: It really is worth taking the time to apply for loans with more than one lender!)
Loan-to-value ratio, or LTV ratio. Mortgage lenders love their ratios! This one is a percentage that compares the amount of your mortgage loan to your home’s actual value. This, too, helps lenders assess risk. The higher the LTV ratio, the higher the risk to lenders.
Mortgage. Most homeowners can’t afford to buy their homes outright. A mortgage is a special type of loan that helps would-be homeowners borrow enough money to buy their homes over time.
Origination fee. It costs money to process a mortgage. This upfront, often negotiable fee charged by your lender compensates them for processing your application and putting your loan in place.
PMI, or private mortgage insurance. Higher-risk mortgage loans (i.e., loans for which the LTV > 80%) require PMI, which is insurance that helps protect lenders from financial loss in the event borrowers default. If you can’t afford a 20% down payment, expect to talk about PMI.
Points. In mortgage-speak, points (aka “discount points”) are lender fees paid at closing to lower your interest rate. Look at it as prepaid interest. One point typically equals one percent of the total amount of your mortgage loan. The more points you pay, the lower your mortgage’s interest rate.
Pre-approval. This is often step two for prospective homebuyers. It means that, based on verified financial data and documentation, a mortgage lender has made a conditional written commitment to provide you with a mortgage loan of a certain amount. Pre-approval — which may require paying a fee — helps buyers show sellers they’ll be able to close on the home. (See also “pre-qualification.”)
Pre-qualification. This is often step one for prospective homebuyers. Based on unverified financial data you provide to a potential mortgage lender, pre-qualification helps you understand what size of mortgage you’ll qualify for — essentially how much home you can afford. Do this before shopping for a home. (See also “pre-approval.”) (First-time homebuyers: Seriously, DO NOT skip this step. Know your budget from day one.)
Prepayment penalty. Want to pay off your mortgage early, before its full 15- or 30-year term? You could get slapped with this penalty, which is a fee you may incur to pay off your mortgage early. To ensure payoff flexibility, it’s ideal to avoid having a prepayment penalty (not all mortgages have them).
Principal. Nope, not your friendly school administrator. In a mortgage context, the principal is the remaining balance of your mortgage loan (excluding interest) you have left to pay.
Rate lock. Since interest rates fluctuate, a rate lock is an option that guarantees (for 30-60 days) that your mortgage loan interest rate won’t change between when you make an offer and close on a home. While a rate lock may save you money, it may also mean missing out on a lower rate if interest rates fall.
Refinancing. This is the process of replacing an existing mortgage with a new one. Refinancing may help homeowners pay off mortgages faster, take advantage of better terms or interest rates, or leverage a home’s equity. (First-time homebuyers: Mortgages are not necessarily “one and done.” It’s worthwhile to weigh the pros and cons of refinancing even a few years into your first mortgage.)
Settlement costs. See “closing costs.”
Title. Legally speaking, this isn’t the piece of paper that says you own your home — that’s the deed (see above). The title is the legal term indicating you own the property and have rights to use it. All that said, many folks still refer to a “deed” and “title” interchangeably.
Title insurance. Most lenders will require you to buy lender’s title insurance, which is a type of insurance that provides protection against title disputes or liens. Also on offer is owner’s title insurance, which provides protection against such claims in the future.
Title search. It’d be downright silly to buy a home from someone who doesn’t legally own it. That’s why, before a home is sold, there’s an examination of municipal records to make sure the seller legally owns the home. A title search also helps turn up any liens or claims, helping to protect you from future liability.
Truth in Lending Act. This federal mandate requires mortgage lenders to adhere to regulations about rate disclosure and advertising, providing consumers with clear information about loan costs and terms.
Underwriting. In the context of mortgages, this is the process lenders use to assess the risks involved in granting you a mortgage. It also helps them decide which terms and conditions to offer you.
You did it! You figured out all the weirdo mortgage words! You can do anything! (Well, maybe not anything. But let’s not needlessly dampen our enthusiasm. Genuinely understanding basic mortgage terms really is a fairly big deal.)
Now, next time you sit down with Michelle, bring on all that ESCROW, PMI, and AMORTIZATION. You’ve totally got this. Understanding your mortgage is within your reach.