Mortgage terms decoded
When you apply for your first home loan, you might feel like you're reading a foreign language. After all, mortgages can be complicated and they include a wide range of unfamiliar words and acronyms.
While you can always consult a mortgage dictionary or call someone to get more information, empowering yourself with some important home loan phrases makes it easier to understand the mortgage process. Here are 15 common terms used in mortgage lending that are important to understand.
What is amortization?
Amortization means lowering a loan balance over a fixed time period. When you take out a home loan, your lender creates an amortization schedule that reflects your monthly mortgage payments. At the end of the term, you will have paid off all of your mortgage and your loan balance will be zero.
Your lender may also use an amortization schedule to easily see when your loan balance will reach a certain amount. For example, you can find out when your balance will reach the 78% loan-to-value (LTV) ratio at which point your private mortgage insurance will end.
What is an ARM?
An adjustable-rate mortgage (ARM), also known as a variable-rate mortgage, has an interest rate that may change over time. The rate is based on a standard market index plus an additional percentage that your lender determines. Your lender can tell you when and how much your interest rate can change with an ARM.
In most cases, an ARM has a low starting interest rate. After a certain number of years, such as five or seven, your rate will adjust periodically. The new interest rate affects your monthly mortgage payment. Rate caps limit the amount your interest rate can change, but your payment could increase quite a bit when the market index goes up.
What is DTI?
Debt-to-income ratio (DTI) reflects how your monthly debts compare to your pretax monthly income. To calculate your DTI, add up all your debts, such as car loans, student loans, minimum credit card payments and the estimated mortgage payment for the house you want to buy. Then, add up your monthly pretax income, including any bonuses and commissions. Finally, divide your debt by your income. The resulting amount is your DTI ratio.
Mortgage lenders use DTI to determine if you can afford a mortgage payment. Lenders often prefer a DTI of 43% or less. If your DTI is higher, some lenders may approve your mortgage but you may need strong compensating factors.
What is an escrow account?
Many lenders require you to put funds for property taxes and homeowners' insurance in escrow. An escrow account holds your funds until your tax and insurance payments are due. Many lenders require you to establish and maintain an escrow account with a cushion equal to two months' worth of tax and insurance payments. Ongoing escrow payments are included in your monthly mortgage payment.
What is an FHA loan?
Many lenders offer home loans backed by the Federal Housing Administration (FHA). Most FHA home loans have less strict financial requirements than conventional loans, which often makes them ideal for first-time homebuyers. FHA loans have benefits like:
- Down payments as low as 3.5% of the home value
- Lower credit score requirements
- Lower reserve requirements
What is a Loan Estimate?
A loan estimate is a form you'll get from your lender within three business days after submitting your mortgage application. The Loan Estimate outlines your loan terms, as well as your projected monthly payments, estimated closing costs and the estimated amount of money you'll need to have on hand in order to close on your loan.
What is home equity?
Home equity refers to the value of your interest in your property, or the amount of your house that you own. When you have a mortgage, your down payment and the principal you've paid contribute to your home equity.
To calculate your home equity, subtract your mortgage balance from the value of your home. You can also calculate your home equity percentage by dividing your home equity by the market value of your property with a home value estimator.
What is a HELOC?
A home equity line of credit (HELOC) lets you use the equity in your home to borrow money. A HELOC is similar to a credit card; you can borrow up to your credit limit, and then you can pay some or all of the amount back and borrow up to your limit again.
You can use your HELOC funds for a wide range of purposes. For example, you could use the funds to pay for home repairs or your kids' college tuition.
What is a Letter of Explanation (LOX?)
A letter of explanation (LOX) is an opportunity for you to explain why there's an issue with your mortgage application. For example, you might write a LOX to explain why your income has changed significantly or to discuss why your credit report shows a late payment.
Writing an effective LOX may help you qualify for a mortgage, even if your credit report or bank statement reflects potentially negative issues. When you apply for a mortgage, ask your lender if writing a LOX would help.
What is LTV?
LTV, or loan-to-value ratio, compares the amount of your mortgage to the appraised value of your property. To calculate LTV on a purchase loan, divide your loan amount by the lesser of the sales price or market value of your home. A refinance generally would only consider the appraised value of your home.
If your LTV is higher than 80%, lenders often require you to pay private mortgage insurance (PMI), and mortgages with an LTV over 80% may also have higher interest rates.
What is MIP?
If you take out an FHA loan, you have to pay a mortgage insurance premium (MIP), also referred to as MMI (Monthly Mortgage Insurance). With an FHA loan, you can expect to pay two types of MIP:
- Upfront MIP: This amount is a set percentage of the loan amount. You may finance or pay this fee up front when you close on your mortgage.
- Annual MIP: This amount is based on the LTV and loan and is based on the average balance of your mortgage, and is included in your monthly mortgage payments.
What are mortgage points?
Mortgage points are fees you can pay your lender to lower the interest rate for your home loan. Buying mortgage points is optional and lets you pay interest up front rather than over the life of the loan.
One mortgage point equals 1% of your loan amount. Buying a mortgage point may lower the interest rate by about 0.25%, but lenders can set their own point values. Ask your lender how much a mortgage point is worth before agreeing to buy any.
What is PITI?
Principal, interest, taxes, and insurance (PITI) refers to your monthly housing expenses. Many lenders use PITI when qualifying you for a mortgage. You may also see it referred to as PITIA, which includes any homeowners' association dues.
What is PMI?
Lenders often require private mortgage insurance (PMI) on a conventional mortgage if your LTV is more than 80%. PMI is included in your monthly mortgage payment and its cost is based on your mortgage balance. PMI varies from loan to loan, and both your LTV and credit score can affect the cost of your insurance.
PMI automatically ends when your LTV reaches 78%. However, you may be able to request early PMI termination when your LTV reaches 80%.
What is an underwriter?
An underwriter is a mortgage professional who assesses your risk level as a borrower. To get a mortgage, an underwriter has to approve your loan application. Most underwriters review the following:
- Your credit score: This number reflects your creditworthiness based on your payment history, types of credit accounts, current balances and age of accounts.
- Your assets and income: Underwriters verify your monthly income and confirm that your assets can cover closing costs and your down payment.
- Your debts: Underwriters typically review your monthly debts and use the total to calculate your DTI.
- Property value: Most lenders require an underwriter to review an appraisal to confirm the value of the property you plan to buy. Then they calculate your LTV to determine if you need PMI.
Whether you have questions about more terms, or want to learn more about the mortgage process, a trusted advisor can help. Find a Home Lending Advisor near you and get the expert advice you need to apply for a mortgage
