10 Mortgage Terms Every Borrower Needs to Know
The first step to joining the nearly 40% of American homes that are now “free and clear” of mortgage debt is to start making the regular monthly payments that lead to financial freedom. If you’re just beginning to navigate the homebuying market, the array of terms can be baffling. Here are the essential mortgage terms you’ll need to add to your glossary, along with some handy tips for working out how much loan you will qualify for.
What Is a Mortgage?
Let’s start with the obvious one. A mortgage is simply an agreement between a borrower and lender to finance the buying of a property. The lender finances the purchase and the borrower repays the debt with interest. Typically, a mortgage will have a fixed term — usually 15 to 30 years — until the balance is cleared. The balance will incorporate any closing costs, such as fees, credit report costs and other expenses on top of the price of the property.
Fixed Rate vs. Adjustable Rate
The vast majority of mortgages in the U.S. are fixed rate, meaning that the monthly repayment stays the same throughout the loan term of the mortgage. Choose this option if you want stability in your monthly budgeting. Adjustable rate mortgages (ARMs) vary according to the interest rate index, and often start off with lower monthly repayments. If interest rates go up, so will monthly repayments. Your repayments will also be affected by several elements.
The length of time a borrower makes payments will depend on their age at the start of the loan and how much they borrow. The shorter the loan term, the lower the amount of interest paid.
The monthly repayment comprises four key elements, known as PITI, representing the principal, interest, taxes and insurance respectively.
The Annual Percentage Rate (APR) is the cost of borrowing from the lender, shown as a percentage of the mortgage total. The APR is more than just the interest rate; it includes broker fees and other charges.
Since a mortgage is a serious financial commitment, it’s important to have a professional, transparent assessment of the property value. This is the appraisal. The cost is covered by the borrower, and it will establish the fair market value of the investment, taking into consideration the property size and condition, local area, and market trends.
Co-signer vs. Co-borrower
The average home price in the USA is just under $250,000, a figure that is out of reach for many younger buyers, particularly when it comes to meeting the usual 10% to 20% downpayment. Many buyers join forces with a family member or partner as a co-signatory to fortify their borrowing power. A co-signatory can be a co-signer or co-borrower.
- i) The co-signer adds their name to the mortgage application, but has no title interest or intention of occupying the property. Their assets, income and credit score support the mortgage application.
- ii) A co-borrower is an additional name on the mortgage application who shares the property.
Both types of co-signatory are liable for the loan.
The amount you will repay over the term of a mortgage is significantly more than the value of the property, due to interest. With amortization, the amount owed reduces with each (monthly) repayment, as opposed to interest-only or non-amortized loans, in which the borrower merely repays the interest each month and repays the principal balance at maturity as a balloon payment. These loans have two downsides: Monthly payments could end up being less than the amount of interest that accrues each month (negative amortization) and the final balloon payment to cover the outstanding balance can be much higher than expected.
Credit Report — How Much Loan Can You Qualify For?
Any mortgage lender will want to see a full credit report on a borrower before proceeding with a loan. The credit report will give details of the borrower’s credit history and payment habits, as well as their existing monthly expenses and debt. Find out more about how to take control of your future score with SmartCredit here.
A key element of your credit score will be your debt-to-income ratio. It is calculated from your monthly debt payments divided by your gross monthly income. As a rule of thumb, it is extremely difficult to secure a mortgage from a lender once your debt-to-income ratio goes beyond 43%, given that the proportion of your income for servicing debt would be precarious.
The principal is the amount of debt left on a loan, not counting interest. If you’re buying a house, for example, the initial principal represents the value of its bricks and mortar. Ideally, the Loan to Value (LTV) ratio will improve during the term of your loan, meaning that the market value of the property you are buying rises faster than the principal you originally borrowed to finance.
In exceptional cases, it might be possible to secure a 100% mortgage on a property, meaning that the lender advances the entire cost of the purchase. In reality, most borrowers will have to save around 10% to 20% of the property value as a downpayment: the upfront lump sum paid to the lender to secure the loan. The more you can afford as a downpayment, the lower the interest you will pay over the term, and the more likely you are to be approved for that mortgage.
Technically, you are not a homeowner until you make the final payment on your mortgage. The degree to which you own the home you are financing is referred to as the equity. The longer you have been making payments, the greater your equity, since you will have been paying off not only the interest but also the principal.
When Foreclosure Happens
Unfortunately, some borrowers encounter financial difficulties at certain points in their mortgage terms, often because of changes in their employment status or a medical condition. If a borrower cannot make monthly payments as agreed, some lenders will allow forbearance, a temporary hiatus or reduction in payments until normal service — payment — resumes. If a borrower is deemed to be delinquent, meaning that they have stopped making payments, the lender can apply to reclaim or foreclose the property. In some states, this requires a court process, but in others, it is non-judicial.
Before hitting the classified ads and interviewing real estate vendors, it would be prudent to learn the lingo as you work out exactly how much you will be able to borrow and what your budget can stretch to. That means reviewing your finances and obtaining your credit score. SmartCredit can help you take control of your future credit score with a consolidated monitoring and reporting dashboard that can provide you with actionable steps. Learn more about SmartCredit here.