Vocabulary: Loans & Lending Terms

Vocabulary: Loans & Lending Terms

Amortization

With each mortgage payment, some of the money reduces the loan balance and some pays interest. This allocation is called amortization. While the earliest payments mostly cover interest, the split changes over time. That’s because as the loan gets smaller, less interest gets charged.

Annual Percentage Rate (APR)

The APR represents the true cost of your credit: interest plus fees and any other one-time costs associated with the loan. Since different lenders have different interest rates and costs, the APR helps you compare apples to apples, mortgage-wise.

Balloon mortgage

This is a form of non-traditional financing where your interest rate will be very low for a short period of time—often three to seven years. Payments usually only cover interest so the principal owed is not reduced. This type of loan may be a good choice if you think you will sell your home at a large profit in a few years.

Closing Costs

Also known as settlement costs, this is the amount of money you need to close the mortgage deal. Closing costs could include title insurance, escrow fees, lender charges, real estate commissions, transfer taxes and recording fees.

Earnest Money

This is the money you give to show you’re serious about this purchase. Earnest money is generally 3% to 5% of the home’s cost. The money goes into an escrow account until financing is arranged; at that point, it gets credited to the purchase price. If the sale doesn’t go through, the seller generally gets to keep the money.

Equity

This is the difference between what you owe on your home and the market value of that home. Equity builds as you pay down the mortgage. It might also grow if home values in your region change noticeably. You can tap this value over time, in the form of a home equity loan, a home equity line of credit or a reverse mortgage.

Escrow

In a real estate transaction, a neutral third party called escrow handles money for buyers and sellers. If you put down earnest money, for example, it goes into escrow until the purchase is complete.

Another example of escrow is the account your lender sets up for homeowners insurance and property taxes. A portion of each mortgage payment goes into the account.

If the mortgage you choose doesn’t require an escrow account, the Consumer Financial Protection Bureau (CFPB) suggests you ask for one. Paying as you go makes it easier to budget for these expenses, rather than coming up with the money for the tax bill or insurance premium all at once.

Fixed vs. Adjustable Interest Rates

A fixed rate allows you to lock in a low interest rate as long as you hold the mortgage and, in general, is a good choice if interest rates are low. An adjustable-rate mortgage (ARM) usually offers a lower rate that will rise as market rates increase. ARMs usually have a limit as to how much and how frequently the interest rate can be increased. These types of mortgages are a good choice when fixed interest rates are high or if you expect your income to grow significantly in the coming years.

Government-backed loans

These loans are sponsored by agencies such as the Federal Housing Administration or the Department of Veterans Affairs. They offer special terms, including reduced interest rates to qualified buyers. VA Loans are open to veterans, reservists, active-duty personnel, and surviving spouses and are one of the only options available for zero down payment loans. FHA loans are open to anyone, and while they do require a down payment, it can be as low as 3.5 percent. Drawbacks include a slower loan process and—for FHA loans—the need to pay mortgage insurance.

Loan Estimate

In the past, lenders gave applicants something called a “good faith estimate,” which listed settlement charges and mortgage terms. As of October 2015, the CFPB instituted a new version called a “loan estimate.” Part of the CFPB’s “Know Before You Owe” program, the loan estimate is a simpler way for consumers to understand the total cost of a mortgage and to shop for the best loans.

Lenders have three business days to provide the loan estimate to applicants. Among other things, it explains the specified loan amount, interest rate (including the APR), estimated monthly payments, estimated assessments, insurance and taxes, and the estimated cash needed at closing.

The CFPB has a Loan Estimate Explainer page that explains these terms.

Mortgage Insurance

In the case of default, mortgage insurance protects the lender. Generally it’s required for borrowers who put down less than 20%.

In government-backed mortgages, mortgage insurance takes several forms:

  •  With Federal Housing Administration (FHA) loans, borrowers pay an upfront fee and an annual premium.
  •  For U.S. Department of Agriculture (USDA) mortgages, borrowers also pay money upfront plus an ongoing premium.
  •  Veterans with VA loans usually pay a one-time fee at closing.

For conventional (non-government) mortgages, coverage is provided by private insurers and is known as private mortgage insurance (PMI). The cost amounts to another 0.15% to 1.95% on your mortgage each month. After you reach 20% equity in your home, you can request that PMI be canceled.

Non-traditional mortgages

Also sometimes called “exotic,” these mortgage types were common in the run-up to the housing crisis, and often featured loans with low initial payments that increase over time.

Points

When you buy points, you’re paying more upfront in exchange for a lower interest rate, which means you pay less over time. Each point equals 1% of the mortgage.

Pre-approval, Pre-qualification

These terms are sometimes used interchangeably, so what they actually mean depends on your lender.

“Pre-qualification” might mean you have given some basic information (income, debts, anticipated down payment) and signaled your desire for a mortgage, without submitting any actual documentation. “Preapproval” might mean that the lender has checked you out more thoroughly, from your credit score to your job history.

However, some lenders use their own terms, such as “credit-only approval,” and the CFPB uses “preapproval” as a catchall term.

Principal

The principal is the amount you borrowed. A portion of each mortgage payment goes toward principal and another portion goes toward the interest.

Rate

Expressed as a percentage, this is the cost you pay to borrow money. It does not include any other charges associated with the mortgage loan. The interest rate you receive is influenced by multiple factors, including, but not limited to, your credit score, the type and length of the loan, the down payment and the price of the home.

Rate Lock

Also known as a lock-in, this is a guarantee that the interest rate won’t change between the day you make your offer and the day you close on the home (provided there are no changes to your mortgage application). Generally the rate lock period runs from 30 to 60 days, although it can be longer. If interest rates are fluctuating noticeably, locking in a rate can save you money.

Term

Mortgages are generally available at 15-, 20-, or 30-year terms. In general, the longer the term, the lower the monthly payment. However, shorter terms mean you pay less interest over the life of the loan.

Underwriting

This is the review of your loan application, to see if it should be approved. Underwriting is part of the lender’s origination fee. Among other things, it takes into account your credit history, income, assets and liabilities and the appraisal of the home you want to buy. Based on the underwriter’s findings, the loan will be approved or denied.

These are just some of the common mortgage terms you’ll need to know when shopping for a home.  As you learn common mortgage terms, you’ll be better prepared to explore buying a new home. Everything you learn will position you to make the best choices for your finances and your future.