If you’re planning to buy a home in the not-too-distant future, there are some key terms that you should familiarize yourself with. Buying a home can be incredibly stressful but going into the process with some preparation and clarity can make it smoother and less confusing.
Here are some mortgage-related terms to focus on:
- Amortization. The process of repaying a loan in monthly installments over time. When you make a monthly mortgage payment, part of the payment goes toward paying down the loan balance (the principal) while part of the payment goes toward interest charges. Because interest is charged on the outstanding loan balance, the percentage of your monthly payment that goes toward interest will decrease over time as you pay down your loan balance.
- APR: Your annual percentage rate, or APR, is a measure of the yearly cost involved with your mortgage. It reflects not only the interest you’ll pay, but any additional charges associated with the loan such as points, origination fees, etc. For this reason, the APR is typically higher than the interest rate.
- Closing Attorney: A lawyer who is responsible for overseeing the legal aspects of a real estate transaction. While closing attorneys are not required in all states, both Massachusetts and Rhode Island require that a closing attorney is present at all real estate closings. A closing attorney will typically be recommended by your lender or realtor, and you’ll pay for the attorney as part of your closing costs.
- Closing Costs: Any expenses involved with the loan beyond the property’s sales price. Common closing costs involved with buying a home include title search fees, loan origination fees, and appraisal fees. These fees are typically paid as a lump sum when you close on your loan, but some lenders do allow you to roll them into your mortgage balance. If considering this option, keep in mind that it will result in a higher monthly mortgage payment and additional interest charges over the life of the loan.
- Debt-to-Income Ratio: The calculation used by a mortgage underwriter to assess your ability to repay outstanding debts. Your debt-to-income ratio is determined by dividing your total monthly debt payments by your gross monthly income (in other words, your monthly income before taxes), and then multiplying that figure by 100 to get a percentage. Most lenders prefer a debt-to-income ratio below 36%.
- Down Payment: A portion of the total purchase price that you will pay upfront for the home. The remaining balance is financed through your mortgage and paid back via your monthly mortgage payments. So, the more money you put down on the home, the lower your monthly payment will be. In most cases, a down payment of at least 20% is required in order to avoid having to pay private mortgage insurance (PMI) on top of your loan. However, there are some loan options with low- and no-down payment requirements, particularly for first-time homebuyers.
- Earnest Money: A deposit that you agree to put down on the home when making an offer. While earnest money is not required, it has become common practice, especially in a seller’s market. An earnest money deposit shows the buyer you are serious about buying the home and can help increase the chance of your offer being accepted. These deposits typically range from 1% to 3% of the home’s sales price but can be higher in a very competitive market. If your offer is accepted, the earnest money is deposited into an escrow account. Once the home sale is complete, you can get your money back or put it toward your down payment or closing costs.
- Escrow Account: An account that holds a portion of your monthly mortgage payment for property taxes and homeowners insurance premiums. An escrow account can also be used to hold the earnest money payment that a borrower puts down with their offer. The lender or mortgage servicer is typically the one who sets up and manages the escrow account.
- Home Appraisal: An objective, professional estimate of the property’s market value. The appraisal is used by the lender to determine the maximum loan amount they are willing to provide. A home appraisal is required when obtaining a mortgage for a home purchase and is required for most refinances as well.
- Home Equity: The difference between the current value of your home and your outstanding mortgage balance. As you make monthly payments toward your mortgage balance, you will free up additional home equity. It’s possible to tap into your home equity down the road by taking out a home equity loan or home equity line of credit.
- Home Inspection: A professional assessment of the home’s physical structure and major systems. An inspection should identify any safety or quality issues with the property. While an inspection is not typically required, it is highly recommended that a buyer have one done on the property prior to loan closing. If significant problems or defects are found during the inspection that weren’t previously disclosed by the seller, the buyer can use that information to renegotiate with the seller or withdraw from the purchase contract.
- Homeowners Insurance: An insurance policy that covers your home and personal belongings in the event of damage or theft. It can also cover detached structures on your property, such as garages and sheds. Typically, a homeowners insurance policy will also cover your liability for injuries that occur on your property. It’s important to carefully review your insurance policy to understand what is and isn’t covered. In some cases, you may need to purchase supplemental coverage such as flood insurance or sewer backup coverage.
- Interest Rate: A percentage that reflects the amount of the outstanding mortgage balance you’ll pay to the lender in interest fees each year. Your mortgage interest rate will either be fixed or adjustable. With a fixed rate mortgage your interest rate will remain the same throughout the life of the loan, while an adjustable rate can change over time.
- Loan-to-Value Ratio: A ratio that is used to determine how much of a property’s value will be financed by the mortgage. The loan-to-value ratio (or LTV) is found by dividing the loan amount by the property’s appraised value and multiplying that amount by 100 to get a percentage. Most mortgage lenders prefer a loan-to-value ratio of 80% or less.
- Mortgage Points: Also known as discount points, mortgage points are one-time fees that can be paid to lower the interest rate on a mortgage. Typically, one point will cost you 1% of the total loan amount and will lower your interest rate by 0.25%. Points are paid for upfront at closing. Since points cut your interest rate, they can save you a significant amount over the life of the loan.
- PITI: An acronym used for Principal, Interest, Taxes, and Insurance, which are the four components of most monthly mortgage payments. Any borrower with an escrow account will pay a portion of their homeowners insurance and real estate taxes each month as part of their monthly mortgage payment, along with their principal and interest payments.
- PMI: Short for “private mortgage insurance”, PMI is an additional payment that is typically required if your down payment is less than 20%. It protects the lender in the event that you default on your loan.
- Prepayment Penalty: A penalty fee that some lenders charge if you pay off your mortgage loan or refinance it prior to the end of your mortgage term. Some lenders even charge a prepayment penalty if you sell your home prior to the end of your mortgage term. Prepayment penalties have become less common over the past decade, but you should still check to see whether your loan is subject to one before closing.
- Principal: Your outstanding mortgage balance. In other words, the amount you owe on your home, not including any interest, taxes, or insurance.
- Property Taxes: The taxes that your city or town assesses on your home each year. If your mortgage includes an escrow account, you will pay towards your annual property taxes each month as part of your monthly mortgage payment. Your lender or mortgage servicer will hold the funds in an escrow account and will pay the taxes on your behalf once they come due.
- Title Search: An examination of public records to confirm a property’s legal ownership and whether the property is free of liens and record-keeping errors that would prevent it from being sold. A title search is typically conducted by a title company and can take around 12 days to complete. A title company will usually be recommended to you by your realtor, lender, or closing attorney.
- Underwriting: The process a lender uses to determine whether a mortgage application should be approved. During the underwriting process, the underwriter will assess your financial situation to determine the risk involved with lending to you. They will review your credit history, income, outstanding debts, savings, and other assets. They will also review the property value provided in the home appraisal.
Whether you’re buying your first home or are a repeat buyer, familiarizing yourself with the mortgage process and its key terminology will help make things clearer and give you the confidence you need to get into the home of your dreams. If you are currently shopping for a mortgage, or thinking about starting the homebuying process, contact us today!