Not many of us have the good fortune of winning the lottery or making a salary large enough to pay cash for our homes. Chances are, if you’re ready to purchase your first home, you’re going to need a mortgage loan to pay for most of your purchase. Mortgage loans can be confusing and there are many different terms associated with the process. Let’s talk about the definitions and some of the risks and benefits associated with the most common terms you might hear in the process.
Conventional Loan – A mortgage loan that is not guaranteed or insured by any government agency, including the Federal Housing Administration (FHA) or the Department of Veterans Affairs (VA). It typically has a fixed term and a fixed rate of interest. These are a great option for those with an excellent credit score, little or no debt and some assets or savings already tucked away.
FHA Loan – A mortgage loan guaranteed by the Federal Housing Administration (FHA) with a down payment as little as 3.5% or a lower credit score. While the loan is guaranteed by the FHA, the borrower must pay mortgage insurance premiums to help protect the mortgage company in the event the loan is not paid back. This can cause mortgage payments to be more expensive due to the extra amount being paid for insurance each month, and those with lower credit scores likely will end up with a higher interest rate.
VA Loan – A mortgage loan partially guaranteed by the U.S. Department of Veterans Affairs (VA) that typically carries a lower interest rate than traditional financing methods. This type of mortgage can only be used for a primary residence. As the name suggests, eligibility to apply through this program typically requires you to be a current military service member, veteran, reservist or National Guardsman.
ARM – Also known as an Adjustable Rate Mortgage or a variable-rate mortgage meaning that the interest rate will change over time. Generally, these are issued with a lower rate of interest than a comparable fixed-rate mortgage at first, and then the interest rate adjusts over a schedule. If you have a “5/1 ARM” loan, the introductory rate will last for the first 5 years, and then can change once per year for the remaining term in the mortgage. Your mortgage payment adjusts to each new interest rate, and most of the time, that means it will keep going up. This can be a shock to those who stick to a planned budget.
PMI – Private Mortgage Insurance sounds like something that would protect the person making mortgage payments, but it really protects the lender. If you purchase a home and put down less than 20%, you’ll likely be required to pay for PMI to protect the lender in the event you don’t pay back your loan as planned. Once the loan balance reaches 80% of the home’s value, you can ask the lender to drop the mortgage insurance premiums.
Points – Most of the time when you hear “points”, it’s referring to points you earn with a credit card. When you hear this term related to a mortgage, it refers to fees you pay to your mortgage lender at closing in exchange for a reduced interest rate on your loan, which can lower your monthly mortgage payment. One “point” costs 1% of your mortgage amount, or rather $1,000 for every $100,000 in your mortgage loan. If you plan to own your home for a long time, paying points at closing can save you a significant amount of interest over the life of the loan.
APR – Annual Percentage Rate represents the true cost of your loan since various lenders can have different interest rates and loan origination fees. This value will allow you to compare apples to apples in the mortgage world.
Down payment – The portion of the total sales price of you home that you pay in cash. These are usually expressed as a percentage, rather than a dollar amount. The more you put down, the more a mortgage lender may view you as “invested” in the property, which can affect the interest rate on your mortgage.
Closing costs – These costs generally include things like title insurance, escrow fees, commissions for a real estate agent, loan origination fees paid to your mortgage lender, and recording fees to officially file your house deed. They’re what you need to pay to seal the deal, or close on your home. In general, you can expect to pay anywhere between 2% and 5% of the purchase price in total closing costs. That’s in addition to your down payment.
Escrow – This can mean a few different things during the home buying process, but when it’s related to your mortgage, it refers to a pool of money your mortgage company collects and then pays out on your behalf for things like homeowners insurance and real estate taxes. A monthly amount needed to pay for these is usually calculated by the mortgage company, which is then added to your monthly mortgage payment.
Equity – Equity is an asset, meaning it’s part of your net worth. It’s calculated by taking the current value of your home and subtracting the outstanding balance of any loans or liens on the property. It can be used toward things like buying your next home or borrowing for home improvements.
Amortization schedule – This table of numbers shows you how much you pay in principal and interest over the life of your loan. At the beginning of a fixed rate mortgage, the majority of your payment is going toward paying the interest on your loan. As time goes on, more of the payment is credited to pay down the principal of the original loan amount. Always look at the amortization schedule. It can be eye opening when determining the number of years you’d like your loan to last.
Underwriting – The process of underwriting occurs when have you have applied for a mortgage loan. The underwriter assigned to your case will conduct research to determine the likelihood that you’ll pay back the money you borrow for your mortgage. This process helps to establish whether or not you’ll be approved for a loan, if there’s enough collateral (the value of the home you’re purchasing) to cover the loan if you default on your payments, the amount for which you’ll be approved to borrow, and the interest rate you’ll need to pay if you agree to the loan.
Now that you’ve expanded your mortgage vocabulary, I hope you’ll feel more confident in your future discussions on the topic. Keep in mind that the type of mortgage loan you choose should be based on what’s best for your unique situation. Check out this article from Nerdwallet that explains what a mortgage broker is and how they may be able to help you figure out the best fit. Also, stay tuned this month for more to come on mortgages, the home buying process, and tips and tricks to stay away from becoming house poor.