Understanding Basic Mortgage Terms

By: John Packman

Purchasing your first home can be daunting and most people require a mortgage. With so many financial terms used in the mortgage industry, the whole process can quickly become confusing. While online mortgage software programs can help determine how much house you can afford on your budget, you still need to understand the terminology to navigate the process. Consult our primer on the most common mortgage terms below to help you get started.

Mortgage - The loan that helps buyers pay for a new home. The property itself is the collateral for the loan, so if payments are not made for an extended period, the bank or company making the loan can take the house and property.

Term - The life or length of the mortgage. The most common mortgages today are 15 or 30-year mortgages, although 20-year mortgages are also available. Each has pros and cons. You will pay less interest with a shorter-term mortgage, but monthly payments will be higher.

Principal - The actual dollar amount a homebuyer borrows to purchase the property. In most cases, the principal will be the purchase price minus whatever down payment the buyer has made.

Escrow Account - The account that buyers pay into when making monthly mortgage payments. Often required by mortgage lenders, the funds from an escrow account are used to pay property taxes, mortgage insurance premiums, hazard insurance, and other coverage. The use of an escrow account protects the borrower and lender. The lender knows bills are being paid and the borrower does not have to remember to pay the taxes and insurance policies separately.

Interest - A percentage of the principal charged by the lender in exchange for the use of the loan. The interest charged varies depending on many factors such as credit score, type of mortgage, and amount of the loan. For most, this means paying interest for 15 to 30 years. Luckily, most lenders use software to give you an estimate of the interest you will pay and help you decide if you want the loan.

Amortization - The way mortgage payments are structured over time. In the beginning, most of your monthly payment is applied towards interest. As time goes on, the amount applied to principal increases.

Adjustable Rate Mortgage (ARM) - A mortgage with an adjustable interest rate that can increase or decrease at predetermined intervals. During the beginning of an ARM loan, the interest rate is generally low. It may become higher (or lower) as time passes. Adjustments to the interest rate are based on one of three indexes: the yield on U.S. Treasury bills, the Cost of Funds Index (COFI), or the London Interbank Offered Rates (LIBOR). While lower payments at the beginning of an ARM loan are desirable for some, borrowers run the risk of their interest skyrocketing in the future.

Fixed Rate Mortgage (FRM) - A mortgage with an interest rate that does not change over time. Monthly payments are the same throughout the term of the loan; however, interest rates are usually higher than those paid on an ARM.

Subprime Mortgage - A mortgage loan for a borrower with less than perfect credit. Subprime loans feature a slightly higher interest rate to protect the mortgage lender from possible defaults or repeated late payments. To determine the risk of a subprime borrower, lenders use complex mortgage software.

Loan-to-Value Ratio (LTV) - The amount of money borrowed versus the value of the home. For instance, a 75% LTV means the mortgage is for $75,000 and the home is worth $100,000. Higher LTVs generally indicate a higher interest rate and additional mortgage insurance.

These are the basics. Knowing and understanding these terms will help you find the right mortgage for your needs and budget. No matter what, try to avoid pressure from real estate agents and loan officers. You want to be happy in your new home. Liking your space and being able to afford your mortgage is key.

Good luck!

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