Mortgage Terms 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.  Adjustable-rate mortgage 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.   Adjustment period 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.   Amortization 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.   Amortization tables 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 rises.   Annual 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 APR.   Appraisal value 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 default.   Appreciation rate 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.   Base rate The underlying interest rate used as a benchmark, or index, for pricing variable-rate loans such as adjustable-rate mortgages, auto loans or credit cards.   Closing costs 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.   Cost analysis A cost-benefit analysis that subtracts homeownership benefits from homeownership costs. Included in the calculation of homeownership costs are: Mortgage interest, including points Closing costs Property taxes and homeowner's insurance Private mortgage insurance (PMI) 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 equity) Loan principal repayment (an increase in equity)   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.   Homeowner's insurance 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.   Index 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.   Initial rate 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.   Interest-only mortgage payments 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.   Loan qualification 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 difficult.   Margin 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.   Mortgage points 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).   Negative amortization 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.   Origination fee A loan fee, often as much as one percent of the loan amount, paid to the lender for processing and originating a loan.   Payment cap 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.   Prepaid interest See mortgage points.   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 coverage.   Property taxes Levies assessed on real property. A local assessor can provide information on tax rates.   Savings rate 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).   Tax rates 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 more) and tax 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.   Tax savings 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.   Tax shield 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 of $280.   Term Period of loan, expressed in years. Residential mortgage loans typically are made for 15- or 30-year terms.

 

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