We know that
sometimes all the "jargon" and acronyms can get a little confusing. We
want you to understand the process and the language involved with
acquiring a mortgage loan. After all... its one of the largest
financial transactions you'll ever make, we want you to be informed.
- A mortgage in which the
interest rate is periodically readjusted to a
base rate. For example a one-year ARM is reset once a year, on a
prescribed date, to the current level of the
base rate plus a margin. For one-year ARMs,
the base rate is often the one-year U.S. Treasury bill yield,
adjusted for a constant maturity.
- Frequency that the
interest rate of an adjustable-rate
mortgage is re-priced to the base rate.
For one-year ARMs, the adjustment is made once a year; for
three-year ARMs, every three years; etc.
- Gradual reduction of
debt that occurs as periodic payments are applied to loan principal
and interest at a rate that repays the loan principal by the end of
the loan term.
- Mathematical tables that
show how a mortgage or other loan is gradually repaid by applying
the appropriate amounts of the loan payment to principal and
interest. In the beginning of the repayment period, only a small
portion is applied to reducing the loan principal. As the loan
approaches maturity, the portion of the payment applied to principal
percentage rate (APR)
- The effective interest
rate paid on a loan, expressed as an annual rate. APR measures the
true interest cost of borrowing by including any fees or prepaid
interest involved in obtaining a loan. For instance, if a borrower
pays $500 in closing costs to obtain a $10,000 loan, the APR is
higher than the simple interest rate because the borrower is
repaying a $10,000 loan but only receiving net proceeds of $9,500.
The federal Truth-in-Lending Act requires lenders to disclose the
- A mortgage lender
determines the fair market value of a home by arranging an
independent appraisal of the home's value. The appraisal uses local
real estate market sales activity as a major basis for valuation.
The appraisal value determines how much the lender is willing to
loan. Generally, lenders make mortgage loans of up to 80 percent of
the appraisal/fair market value of the home (see
loan-to-value (LTV) ratio). For instance, a home appraised at
$100,000 can be financed with a first-mortgage loan of $80,000.
Before funding a larger percentage of the appraisal value, lenders
generally require that borrowers obtain
private mortgage insurance (PMI), which protects the lender from
- Percentage increase in
the value of an asset, expressed at an annual rate. A home bought
for $100,000 that appreciates five percent a year will be worth
$127,600 after five years.
- The underlying interest
rate used as a benchmark, or index, for pricing
variable-rate loans such as adjustable-rate mortgages, auto loans or
- Charges associated with
the underwriting and funding of a loan that are paid when the loan
is about to be disbursed and the borrower about to take possession
of the asset. Mortgage closing costs include title search, appraisal
fee, legal and escrow service fees, and mortgage points.
- A cost-benefit analysis
that subtracts homeownership benefits from homeownership costs.
Included in the calculation of homeownership costs are:
Included in benefits are:
Tax shield received from mortgage
interest and points
- Tax shield received
from property taxes
- Appreciation in value
of your home due to market conditions (an increase in
- Loan principal
repayment (an increase in equity)
- Difference in the market
value of a home and the total amount of debt or other encumbrances
used to pay for the home. As market value increases and the borrower
repays the mortgage loan, equity increases.
- Insurance coverage
required by a mortgage lender to insure against such potentially
catastrophic damage to a home (the lender's collateral) as flood,
fire, tornado, or hurricane. Homeowner's insurance also provides
liability coverage in case someone is injured on your property.
Impounds for taxes and insurance
- Typically, a monthly
mortgage payment has four components: principal, interest, taxes and
insurance ("PITI"). The taxes and insurance portions represent
property taxes and homeowner's insurance premium, respectively.
These are often required by the lender to be included in a monthly
payment since regular and timely payment of both of these
obligations improves the lender's collateral position.
- An index is the
benchmark interest rate used by lenders to price loans. For
residential mortgage lending in the U.S., 10-year U.S. Treasurys are
often used for 30-year mortgage loans (on average, most homeowners
live in their homes for a period of time closer to 10 years than 30
years). For adjustable-rate mortgage
loans, the two most common indexes are the one-year, constant
maturity-adjusted Treasury bill and the Eleventh District Cost of
Funds Index (COFI), published by the Federal Home Loan Bank of San
Francisco, a federally chartered thrift institution.
- The starting interest
rate on an adjustable-rate mortgage
loan, which is often below market ARM rates. The intent of a low
initial rate is to assist homebuyers that may not otherwise qualify
for a mortgage loan.
- Mortgage payments that
include only interest. No loan amortization
occurs and, thus, the homeowner does not accrue any
equity (unless the home value increases)..
Interest rate cap
- A limit on the amount
the interest rate can increase. A periodic cap limits how much the
rate can increase at each adjustment
period. A lifetime cap limits how much the rate can increase
during the term of the loan.
Loan-to-value (LTV) ratio
- Loan amount divided by
the fair market value of the collateral, generally the
appraisal value. For instance, a
lender considering an 80 percent LTV on a home appraised at $250,000
would consider a loan request of $200,000. When considering a home
equity loan, the lender will consider the combined LTV,
assuming full disbursement of the equity loan. For instance, if a
lender will consider a 90 percent combined LTV in the same example,
he would consider a home equity loan request of $25,000 for combined
debt that equals 90 percent of the appraisal value.
estimates: aggressive versus conservative
- Lenders relax their
underwriting guidelines when economic times are good and competition
for borrowers increases. This is considered an aggressive
loan-making position. At other times—such as when there are layoffs
or an economic slowdown—lenders will tighten their underwriting
guidelines to make it more difficult to qualify for a loan. This is
considered a conservative loan-making position. If a lender is
aggressively seeking loans, he or she is likely to make it easier to
qualify for a loan. If a lender wants to make only the most
conservative loans, he or she is likely to make qualification more
- The amount a lender adds
to the base rate of an
adjustable-rate mortgage to determine
the loan rate. For instance, if a one-year ARM is priced at a margin
of 300 basis points (100 basis points is equal to one percent) over
the yield on the one-year constant maturity-adjusted Treasury bill,
and the T-bill's yield is 6.5 percent, the one-year ARM rate would
be 9.5 percent.
- One mortgage point
equals one percent of the loan amount (e.g., $1,000 on a mortgage
loan of $100,000). Mortgage points are also called discount points.
The IRS considers points to be a form of prepaid interest which
means they can be deducted from taxable income. Lenders often
require that the borrower pay one or two points at closing in
exchange for a lower mortgage rate (the lender's target
APR remains the same).
- The opposite of
amortization. In the case of an
adjustable-rate mortgage with a
payment cap, a upward adjustment in the
interest rate may cause the loan payment to be insufficient to cover
even the interest portion of the scheduled payment. In this
case, the unpaid interest is added to the mortgage loan principal
(if the loan agreement permits) and the loan amount increases.
- A loan fee, often as
much as one percent of the loan amount, paid to the lender for
processing and originating a loan.
- A limit on the amount
that the monthly payment can increase. A periodic cap limits the
amount of the increase at each
adjustment period. A lifetime cap limits the amount that the
monthly payment can increase during the term of
the loan. A potential peril of payment caps is
negative amortization. In the
case of an adjustable-rate mortgage
with a payment cap, rising interest rates may casue the loan payment
tobe insufficient to cover even the interest portion of the
scheduled payment. In this case, the unpaid interest may be added to
the mortgage loan principal, if the loan agreement permits.
Private mortgage insurance (PMI)
- Paid by a borrower to
protect the lender in case of default. PMI is typically charged to
the borrower when the loan-to-value (LTV) ratio
is greater than 80 percent. The Homeowners Protection Act of 1998
mandates that a lender notify a borrower when the LTV falls below 80
percent, at which time a borrower is allowed to cancel the PMI
- Levies assessed on real
property. A local assessor can provide information on tax rates.
- The interest rate
expected on the most conservative of investments. A conservative
estimate should be used if the money is intended to be invested for
a short time only or the investor is unwilling to risk losing any of
the investment. A money market rate of between 5.5 and 6.5 percent
is a conservative rate (as of June 2000).
- The five federal income
tax rates range from 15 percent to 39.6 percent. To determine the
applicable income tax rate, see the
IRS' tax rate schedules (if adjusted gross income is $100,000 or
tables (for AGI under $100,000). Several states, including
Washington, Alaska, and Wyoming, do not levy income taxes. State
income and excise tax rates at the
Intelligent Taxes Web site.
- The amount saved on
taxes by itemizing deductions on income tax returns Mortgage
interest and property taxes are tax-deductible, and therefore
generate a tax shield benefit.
- The amount saved in
taxes by taking deductions. To measure the tax shield benefit,
multiply the amount of the deduction by your tax rate. For instance,
if an investor deducts $1,000 in mortgage interest expense and is in
the 28 percent income tax bracket, she enjoys a tax shield benefit
- Period of loan,
expressed in years. Residential mortgage loans typically are made
for 15- or 30-year terms.
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