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The homebuying process can be full of new terminology, especially as a first-time homeowner. Here is a quick overview of common mortgage terms. This will give you the tools and confidence to communicate with a Mortgage Professional about your options.
Key mortgage terminology
Adjustable-rate mortgage (ARM)
An adjustable-rate mortgage (ARM) starts with a fixed interest rate for a limited period but “adjusts” afterward. These loans can be appealing because they generally start with a lower interest rate than a fixed-rate mortgage. ARMs also carry risk because interest rates can adjust up over time based on market conditions. The most common fixed-rate periods for ARMs are 3, 5, or 7 years, according to the Consumer Financial Protection Bureau. And a common adjustment period is 1. Putting everything together, you may see lenders advertise a “5/1 ARM,” for example. That ARM would have a fixed rate for 5 years and adjust once (1 time) per year afterward.
Amortization is one of the more difficult mortgage terms to grasp, but it makes budgeting a mortgage payment easier. It is the action of repaying your mortgage (principal and interest) in equal installments over the length of your loan. The equal installments make payments predictable. To better understand amortization, mortgage lenders and mortgage calculators provide amortization schedules. These show how payments break down over time. The example below shows how the first three payments would break down on a sample 30-year loan. Notice that the principal and interest always add up to the mortgage payment (in bold).
Most home loans amortize over a 15- or 30-year term. Once a loan is “fully amortized,” that means a borrower has paid it all off by the end of the set amortization schedule.
Annual percentage rate (APR)
Annual percentage rate or APR represents the cost of borrowing the money for a mortgage. APR is different from the interest rate because—on top of the interest rate—it also factors in other mortgage costs. These could include closing costs, discount points, and other fees included with the loan. Therefore, APR is generally higher than the interest rate. When you’re estimating the actual cost of a loan, the APR will be more accurate than an interest rate.
Discount points,* or mortgage points, are mortgage terms to know if you want to reduce your interest rate. They are a type of prepaid interest or fee borrowers pay for a lower interest rate. One discount point will typically cost you 1% of your loan amount and reduce a borrower’s rate by 0.25% or more. You can also buy partial points. Try our mortgage calculator to estimate how much discount points could save you over the life of your loan.
*Note: Some lenders use the term “points” to refer to things that don’t relate to discounting interest rates. It may apply to other fees that are based on a percentage of your loan.
Escrow can also be one of the trickier parts of mortgage terminology to understand because its meaning can vary depending on the context. For home purchasing purposes, escrow generally refers to a period of time where funds are held by a neutral third party. It holds funds that will transfer between the parties involved in the transaction while the buyers and sellers prepare to close. These can include funds such as earnest money deposits, down payments, monies for closing costs, and even a home’s purchase price. Once a real estate agreement is fulfilled or cancelled, the funds are distributed to the appropriate parties.
An escrow period should not be confused with an escrow account that is created after the loan is funded. That escrow account is used during the life of the loan for paying property taxes and insurances (hazard, flood, wind, or mortgage insurance).
You may not think of credit scores as mortgage terms, but FICO Scores are one to know.
They are the most widely used credit score brand in lending. They were created by Fair Isaac (FICO), a data company, and factor in a borrower’s:
- Payment history
- Amounts owed
- Length of credit history
- New credit accounts
- Credit mix (types of credit used)
FICO Scores are based on information the three major credit reporting agencies—Equifax, Experian, and Transunion—collect. Because that information can vary, a borrower can have three different base scores. FICO Scores are also available for specific types of lending, such as mortgages. Mortgage lenders typically focus on the middle score among the three scores they use. Increasing your credit score is often a good plan before buying a home to get the best possible mortgage rate. Read our blog “How To Boost Your Credit Score Before Buying a House” to learn more.
The loan-to-value ratio calculates how much of a property you own (equity) compared to how much you owe still on the loan. As you continue to pay off your loan, your LTV ratio decreases as your equity, or ownership, grows. For a home loan, an LTV ratio of 80% or less is ideal. Mortgages with LTV ratios greater than 80% typically require PMI.
Private mortgage insurance (PMI)
Private mortgage insurance (PMI) protects your loan’s investor (the entity that owns the loan) in case a borrower defaults. Lenders may require private mortgage insurance if your down payment is less than 20% of the loan amount. PMI is one of homeowners least favorite mortgage terms because it’s an added cost. If you are required to carry PMI, it may be removed when the equity in your home reaches a certain percentage.
Note: Depending on the type of loan you have, your mortgage insurance may go by different names. It can be called Private Mortgage Insurance (PMI) or Mortgage Insurance Premium (MIP).
Once you get your rate lock, your interest rate won’t change between the offer and closing. This is as long as you close within the specific timeframe and there are no changes to your application. Rate locks are helpful because rates can change quickly. They can change daily and even hourly, the CFPB explains, and mortgages can take weeks to close.
No matter where you are in your homebuying journey, our experienced Mortgage Professionals are ready to help you understand your loan options. Contact us today at 833-702-2511 or get started online.
FICO® is a registered trademark of Fair Isaac Corporation