04/07/2022: Key Terms for Homebuyers
Adjustable Rate Mortgage (ARM)
An adjustable rate mortgage (ARM) is a type of loan for which the interest rate can change, usually in relation to an index interest rate. Your monthly payment will go up or down depending on the loan’s introductory period, rate caps, and the index interest rate. With an ARM, the interest rate and monthly payment may start out lower than for a fixed-rate mortgage, but both the interest rate and monthly payment can increase substantially. Learn more about how ARMs work and what to consider at consumerfinance.gov.
5/1 Adjustable Rate Mortgage
A 5/1 adjustable rate mortgage (ARM) or 5-year ARM is a mortgage loan where “5” is the number of years your initial interest rate will stay fixed. The “1” represents how often your interest rate will adjust after the initial five-year period ends. The most common fixed periods are 3, 5, 7, and 10 years and “1,” is the most common adjustment period. It’s important to carefully read the contract and ask questions if you’re considering an ARM. You can learn more about how adjustable rates change at consumerfinance.gov.
Amortization means paying off a loan with regular payments over time, so that the amount you owe decreases with each payment. Most home loans amortize, but some mortgage loans do not fully amortize, meaning that you would still owe money after making all of your payments.
Some home loans allow payments that cover only the amount of interest due, or an amount less than the interest due. If payments are less than the amount of interest due each month, the mortgage balance will grow rather than decrease. This is called negative amortization. Other loan programs that do not amortize fully during the loan may require a large, lump sum “balloon” payment at the end of the loan term. Be sure you know what type of loan you are getting.
Annual Percentage Rate (APR)
An annual percentage rate (APR) is a broader measure of the cost of borrowing money than the interest rate. The APR reflects the interest rate, any points, mortgage broker fees, and other charges that you pay to get the loan. For that reason, your APR is usually higher than your interest rate.
You’ve chosen a home you want to buy and your offer has been accepted. You’ve also applied for and been approved for a mortgage. Now you are ready to take legal possession of the home and promise to repay your loan. At least three days before your closing, you should get your official Closing Disclosure, which is a five-page document that gives you more details about your loan, its key terms, and how much you are paying in fees and other costs to get your mortgage and buy your home.
Many of the costs you pay at closing are set by the decisions you made when you were shopping for a mortgage. Charges shown under “services you can shop for” may increase at closing, but generally by no more than 10% of the costs listed on your final Loan Estimate. The Closing Disclosure breaks down your closing costs into two big categories:
Your Loan Costs:
- The lender’s Origination Costs to make or “originate” the loan, along with application fees and fees to underwrite your loan. Underwriting is the lender’s term for making sure your credit and financial information is accurate and you meet the lender’s requirements for a loan.
- Discount points—that is, additional money you pay up front to reduce your interest rate.
- Services you shopped for, such as your closing or settlement agent and related title costs.
- Services your lender requires for your loan. These include appraisals and credit reports.
- Property taxes.
- Homeowner’s insurance premiums. You can shop around for homeowner’s insurance from your current insurance company, or many others, until you find the combination of premium, coverage, and customer service that fits your situation. Your lender will ask you for proof you have an insurance policy on your new home.
- Any portion of your total mortgage payment you must make before your first full payment is due.
- Flood insurance, if required.
Get tips, a step-by-step checklist, and help with the rest of the documents you’ll see at closing at consumerfinance.gov/owning-a-home.
A down payment is the amount you pay toward the home upfront. You put a percentage of the home’s value down and borrow the rest through your mortgage loan. Generally, the larger the down payment you make, the lower the interest rate you will receive and the more likely you are to be approved for a loan.
Earnest money is a deposit provided to a seller to show that the buyer is serious about purchasing a residence. The funds allow the buyer more time to secure financing and complete title searches, appraisals, and inspections before to closing. Earnest money is similar to a down payment on a house, an escrow deposit, or good faith money in many aspects.
Equity is the amount your property is currently worth minus the amount of any existing mortgage on your property.
An escrow account is set up by your mortgage lender to pay certain property-related expenses, like property taxes and homeowner’s insurance. A portion of your monthly payment goes into the account. If your mortgage doesn’t have an escrow account, you pay the property-related expenses directly.
FHA loans are loans from private lenders that are regulated and insured by the Federal Housing Administration (FHA). FHA loans differ from conventional loans because they allow for lower credit scores and down payments as low as 3.5 percent of the total loan amount. Maximum loan amounts vary by county.
Flooding causes more than $8 billion in damages in the United States in an average year. You can protect your home and its contents from flood damage. Depending on your property location, your home is considered either at high-risk or at moderate-to-low risk for a flood. Your insurance premium varies accordingly. You can find out more about flood insurance at FloodSmart.gov. Private flood insurance could also be available.
Although you may not be required to maintain flood insurance on all structures, you may still wish to do so, and your mortgage lender may still require you to do so to protect the collateral securing the mortgage. If you choose to not maintain flood insurance on a structure, and it floods, you are responsible for all flood losses relating to that structure.
Home Inspector and Home Appraiser
When you are considering buying a home, it is smart to check it out carefully to see if it is in good condition. The person who does this for you is called a home inspector. The inspector works for you and should tell you whether the home you want to buy is in good condition and whether you are buying a “money pit” of expensive repairs. Get your inspection before you are finally committed to buy the home.
A home inspector is different from a home appraiser. The appraiser is an independent professional whose job is to give the lender an estimate of the home’s market value. You are entitled to a copy of the appraisal prior to your closing. This allows you to see how the price you agreed to pay compares to similar and recent property sales in your area.
Home Equity Line of Credit (HELOC)
A home equity line of credit (HELOC) is a line of credit that allows you to borrow against your home equity. Equity is the amount your property is currently worth, minus the amount of any mortgage on your property. Unlike a home equity loan, HELOCs usually have adjustable interest rates. For most HELOCs, you will receive special checks or a credit card, and you can borrow money for a specified time from when you open your account. This time period is known as the “draw period.” During the “draw period,” you can borrow money, and you must make minimum payments. When the “draw period” ends, you will no longer be able to borrow money from your line of credit. After the “draw period” ends you may be required to pay off your balance all at once or you may be allowed to repay over a certain period of time. If you cannot pay back the HELOC, the lender could foreclose on your home.
*Not available in Texas
Homeowner’s insurance pays for losses and damage to your property if something unexpected happens, like a fire or burglary. When you have a mortgage, your lender wants to make sure your property is protected by insurance. That’s why lenders generally require proof that you have homeowner’s insurance. Homeowner’s insurance is not the same as mortgage insurance.
An interest rate on a mortgage loan is the cost you will pay each year to borrow the money, expressed as a percentage rate. It does not reflect fees or any other charges you may have to pay for the loan. For example, if the mortgage loan is for $100,000 at an interest rate of 4 percent, that consumer has agreed to pay $4,000 each year he or she borrows or owes that full amount.
The loan-to-value (LTV) ratio is a measure comparing the amount of your mortgage with the appraised value of the property. The higher your down payment, the lower your LTV ratio. Mortgage lenders may use the LTV in deciding whether to lend to you and to determine if they will require private mortgage insurance.
Mortgage insurance protects the lender if you fall behind on your payments. Mortgage insurance is typically required if your down payment is less than 20 percent of the property value. Mortgage insurance also is typically required on FHA and USDA loans. However, if you have a conventional loan and your down payment is less than 20 percent, you will most likely have private mortgage insurance (PMI).
An origination fee is what the lender charges the borrower for making the mortgage loan. The origination fee may include processing the application, underwriting and funding the loan, and other administrative services. Origination fees generally can only increase under certain circumstances.
Private Mortgage Insurance (PMI) is a type of mortgage insurance that benefits your lender. You might be required to pay for PMI if your down payment is less than 20 percent of the property value and you have a conventional loan. You may be able to cancel PMI once you’ve accumulated a certain amount of equity in your home.
A prequalification is when a mortgage lender gathers some basic financial information from you in order to determine how much house you can afford. When you are prequalified for a home loan, you will have a good estimate of how much you will be approved for when it comes time to close.
Property taxes are taxes charged by local jurisdictions, typically at the county level, based upon the value of the property being taxed. Often, property taxes are collected within the homeowner’s monthly mortgage payment, and then paid to the relevant jurisdiction one or more times each year. This is called an escrow account. If the loan does not have an escrow account, then the homeowner will pay the property taxes directly.
When you purchase your home, you receive a document most often called a deed, which shows the seller transferred their legal ownership, or “title,” to the home to you. Title insurance can provide protection if someone later sues and says they have a claim against the home. Common claims come from a previous owner’s failure to pay taxes or from contractors who say they were not paid for work done on the home before you purchased it.
Most lenders require a Lender’s Title Insurance policy, which protects the amount they lent. You may want to buy an Owner’s Title Insurance policy, which protects your financial investment in the home. The Loan Estimate you receive lists the Owner’s Title Insurance policy as optional if your lender does not require the policy as a condition of the loan.
Depending on the state where you are buying your home, your title insurance company may give you an itemized list of fees at closing. This itemized list may be required under state law and may be different from what you see on your Loan Estimate or Closing Disclosure. That does not mean you are being charged more. If you add up all the title-related costs your title insurance company gives you, it should match the totals of all the title-related costs you see on your Loan Estimate or Closing Disclosure. When comparing costs for title insurance, make sure to compare the bottom line total.