Twenty Terms You Must Know and Understand Before You Sign Off On Your Mortgage!

During the emotional excitement of buying a home, you may encounter terms with which you are unfamiliar. For some, it can be a bit embarrassing to ask what they consider too many questions. Others may make a note of their questions but simply forget to revisit them. To ensure that you have complete confidence during your home loan process, invest a moment to read this report and become familiar with the concepts and terms you'll encounter. Knowledge is power and the more you know, the more successful your decisions will be, and the more soundly you will sleep at night having made them.

1. Adjustable Rate Mortgage (ARM) - Also referred to as a Variable Rate Mortgage - a mortgage in which the interest rate is adjusted periodically based on a pre-selected index. For example, consider a 5/1 ARM at 6.25% with 5/2/5 caps and a margin of 2.75 over the LIBOR index:

A. 5/1: the "5" means that the interest rate is fixed for five years. The "1" means that the interest rate adjusts one time every year after the first five years.

B. 6.25% means that the interest rate is fixed at 6.25% during the first five years. This is called the "initial start rate".

C. 5/2/5 caps:

1) The first number - "5" - means that the interest rate can adjust up to 5% over the initial start rate in the first year after the fixed period ends (year 6). This means that if the initial start rate is 6.25%, the interest rate can go up to 11.25% in year six (6.25% initial start rate + 5 = 11.25%).

2) The second number - "2" - means that in every year after the first adjustment in year 6, the interest rate can adjust up or down up to 2% annually.

3) The third number - "5" - means that the interest rate can never go up more than 5% over the initial start rate during the entire life of the mortgage. In this example, the maximum interest rate over the life of the mortgage would be 11.25% (6.25% initial start rate + 5 = 11.25%).

D. 2.75 margin - In this example, the margin of 2.75 over the LIBOR index means that after the first five years, the interest rate would be calculated by adding 2.75 to the LIBOR index at the time of the adjustment. LIBOR stands for "London Interbank Offered Rate".

2. Annual Percentage Rate (APR) - An interest rate that reflects the cost of a mortgage as a yearly rate. This rate takes into account any points and fees (closing costs) and is based on the loan going to its full-term. APR can often be manipulated by lenders and it is often inaccurate with Adjustable Rate Mortgages.

3. Appraisal - A written report containing an estimate of property value and the data on which the estimate is based. Appraisals are prepared by a licensed appraiser who is independent of the seller, buyer, lender and real estate agent. The appraiser inspects the subject property and compares it with other similar properties that have sold in the area to determine the fair market value. The mortgage lender bases the loan-to-value ratio on the appraised value of a property and not its sales price. If you are refinancing a property, an issue called "seasoning" may come into play. This affects which value the lender allows you to use when determining the mortgage balance.

4. Assumption - An agreement between buyer and seller in which the buyer assumes responsibility for the seller's existing mortgage. This agreement could potentially save the buyer money because closing costs and the current interest rates, possibly higher, do not apply. In most residential mortgage transactions, this is not an option because the seller's existing mortgage normally has a "due on sale" clause that requires the seller to pay off the mortgage if the house is sold or if the ownership is transferred. This issue often comes into play with real estate investment strategies.

5. Buy-down - A method of lowering the buyer's monthly payment for a short period of time. The lender or homebuilder subsidizes the mortgage by lowering the interest rate for the first few years of a loan. This strategy can be very effective in today's market.

6. Closing - Also referred to as settlement. The meeting at the conclusion of a real estate sale in which the property and funds are exchanged between the parties involved.

7. Closing Costs - the total points and fees that are associated with completing a mortgage transaction or a house purchase or sale. Often, a good negotiation strategy for both the buyer and seller is for the seller to pay closing costs on behalf of the buyer. 

8. Debt-to-Income Ratio - The ratio, expressed as a percentage, which results from dividing a borrower's monthly payment obligation on long-term debts by the borrower's gross monthly income.

9. Down Payment - Cash paid by the buyer at closing that makes up the difference between purchase price and the mortgage amount.

10. Earnest Money - Money given by a buyer to a seller as a deposit to commit the buyer to the future transaction. Earnest money is subtracted from closing costs.

11. Equity - The value an owner has in real estate over and above the obligation against the property. Equity is fair market value minus the current mortgage and other liens. Real estate equity should be managed just like any other investment.

12. Escrow - Funds given to a third party which will be held to cover payments such as tax or insurance payments and earnest money deposits.

13. Fixed Rate Mortgage - A mortgage in which the interest rate remains constant and fixed throughout the life of the loan.

14. Loan-to-Value Ratio - The ratio between the amount of the mortgage loan and the appraised value of the property.

15. Market Value - The price that a property could possibly bring in the marketplace.

16. Origination Fee - A fee charged by a lender for processing a loan application. This is usually computed as a percentage of the loan and is used by some lenders as another name for "Points".

17. PITI - Refers to Principal, Interest, Taxes, and Insurance.

18. Points - Prepaid interest charged by the lender. One point is equal to 1 percent of the loan amount (on a $200,000 mortgage, 1 point = $2,000).

19. Private Mortgage Insurance (PMI) - Insurance that protects lenders against loss if a borrower defaults. This is required when the loan-to-value ratio is greater than 80 percent. The PMI payment is not tax deductible and is usually added to the monthly mortgage payment. However, there are ways finance up to 100% of your home's value and avoid PMI. These strategies include "Piggyback Mortgages" and Lender Paid Mortgage Insurance. In today's market, Lender Paid Mortgage Insurance can often be the best strategy.

20. Underwriting - The decision-making process of granting a loan to a potential homebuyer.