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If you’re financing a home purchase, understanding mortgage terminology is essential. But becoming fluent can feel a bit like learning a new language. To help, here’s our guide to some of the most common mortgage-related phrases and terms — from A(PR) to V(A loans) — that should demystify the process and aid your shopping around for financing.
Mortgage loan definitions
Adjustable rate mortgage (ARM)
An adjustable rate mortgage is one in which the interest rate on the loan changes at a predetermined time, as often as once a year. There is typically an initial “teaser” period when the interest rate is especially low — even lower than that of a fixed-rate mortgage. After that, the interest can go either up or down based on market conditions.
Amortization describes the process of paying off a loan, such as a mortgage, in installment payments over a period of time. Part of each payment goes toward the principal (the amount borrowed), while the other portion goes toward interest. A typical home loan might amortize over a 15-, 20- or 30-year term, with the amount allocated to interest and principal decreasing and increasing, respectively, over the term. When a loan fully amortizes, that means it’s been paid off entirely by the end of the amortization schedule.
APR, or annual percentage rate, reflects the cost of borrowing the money for a mortgage. A broader measure than the interest rate alone, the APR includes the interest rate, discount points and other fees that come with the loan. The APR is higher than the interest rate and is a better gauge of the true cost of the loan.
A cash-out refinance is a type of loan that allows you to access some of your equity in a lump sum. You will take out a second, larger, mortgage that replaces the first. You take home the cash difference between the two loans.
Closing costs are fees associated with getting a mortgage. They include a variety of expenses paid at the time of the loan signing, or closing, such as an origination fee, appraisal fee, credit report fee and title search fee. Closing costs are generally paid by homebuyers, but sellers may cover some of the costs in certain situations.
Construction loans are a type of short-term financing, usually with a one-year term; the money must be used for the specific purpose of building a new home. You withdraw money at predetermined stages of your project. When the home is finished, you can either pay off the loan or convert it to a traditional mortgage.
A conventional mortgage is any loan not backed by the government; it is financed entirely by the private sector. Unlike FHA or VA loans, which are insured by federal agencies (the Federal Housing Administration and the Department of Veteran Affairs, respectively), a conventional loan places all of the risk on the lender. These loans typically require a larger down payment as a result.
Debt-to-income (DTI) ratio
Debt-to-income (DTI) ratio is a measure of a borrower’s ability to repay a mortgage, and is calculated by adding up all of the borrower’s monthly debt payments and dividing the total by the borrower’s gross monthly income. For example, if a borrower’s debt payments total $4,000 a month and their gross monthly income is $10,000, the DTI ratio would be 40 percent. Many lenders look for borrowers to have a DTI ratio no higher than 43 percent.
The down payment is the amount of a home’s purchase price a homebuyer pays upfront. Buyers typically pay a percentage of the home’s purchase price in cash, then borrow the rest in the form of a mortgage. A larger down payment can help improve a borrower’s chances of getting a lower interest rate. Different kinds of mortgages have varying minimum down payments.
Earnest money is a deposit a homebuyer makes when entering into a purchase and sale agreement for a home, generally as a sign of good-faith intent. The deposit is typically held by a title company in an escrow account. When the home sale closes, the earnest money goes toward the down payment or closing costs. If the sale falls through, the deposit is either returned to the buyer or given to the seller, depending on whether the reason for termination was permitted in the purchase and sale agreement.
Equity is the percentage of your home that you own outright. It’s debt-free, representing the portion of your home that is paid off (and/or that you paid for directly, via your down payment. If a home is valued at $200,000 and your mortgage balance is $100,000, your equity is $100,000.
An escrow account — also called an impound account — is an account that holds the portion of a borrower’s monthly mortgage payment slated for homeowners insurance premiums and property taxes. Escrow accounts also hold the earnest money the buyer deposits between the time their offer has been accepted and the closing. An escrow account for insurance and taxes is usually set up by the mortgage lender or servicer, who makes the insurance and tax payments on the borrower’s behalf. This system assures the lender that those bills are paid, and gives the borrower the convenience of paying for these expenses in small installments each month, instead of being hit with a large bill once or twice a year.
FHA loans are mortgages backed by the Federal Housing Administration (FHA). That means the FHA is insuring them; should you default, it’ll repay the lender — thus reducing the risk of the lender (who actually finances the loan). As a result, FHA loans often have more lenient credit requirements and lower down payments than conventional loans; they’re especially popular with first-time homebuyers.
A fixed-rate mortgage is a loan that carries the same interest rate for the entire term (life of the loan) — in contrast to an adjustable rate mortgage, whose interest rate fluctuates based on market conditions. Borrowers can only change the interest rate on a fixed-rate mortgage by refinancing it.
Forbearance refers to a short pause on mortgage payments, typically because of financial hardship. Once the forbearance period is over, homeowners can either repay the missed payments in a lump sum, enter a repayment plan, or request a loan modification.
Foreclosure is what happens when a homeowner stops making payments on their mortgage; this default allows the lender to take possession of the home, as it acted as collateral for the loan. Foreclosure allows a mortgage lender to sell the home and recoup the money it’s owed.
The interest rate on the loan represents what the lender is charging someone to borrow money. It’s expressed as a percentage applied to every mortgage payment. The interest rate a lender charges reflects market trends, but also the degree of risk involved. Short-term loans often carry lower interest rates than long-term ones (since the lender is getting its money back sooner) and people with better credit scores can often get lower interest rates than applicants with a challenged credit history.
A jumbo loan is a loan for larger and/or more expensive properties — those higher than the general federally-set standards, known as the “conforming loan limits.” Most mortgages fall within these conforming limits, meaning banks are only allowed to lend out a certain amount based on the geographic region where the home is located. For most of the U.S, $726,200 is the ceiling price; in the most expensive areas, the limit for a conforming loan is $1,089,300 (in 2023). If you need more money than that you’ll require a jumbo loan.
A loan estimate is a standardized, three-page document containing details about a mortgage, given to a borrower when they apply for a loan. The loan estimate includes estimates of the interest rate, monthly payment and the total closing costs, and also taxes, insurance, prepayment penalties and other important information about the loan. The loan estimate is designed to make it easier for borrowers to compare terms when shopping for a mortgage — receiving one does not mean they’ve been approved or denied for the loan.
Loan-to-value (LTV) ratio
The loan-to-value ratio, or LTV ratio, is used by mortgage lenders to compare the loan amount against the property value. Typically, an LTV ratio of 80 percent or less — which corresponds to a 20 percent down payment — is ideal. With a conventional loan, an LTV ratio greater than 80 percent means you’ll need to purchase mortgage insurance, an extra expense. Some government-backed mortgages, such as FHA or VA loans, permit higher LTV ratios, and may or may not come with the mortgage insurance requirement.
Mortgage insurance is typically required on home loans where the buyer makes a less-than-20 percent down payment. The premiums are paid by the borrower, usually as part of their monthly mortgage repayment. This extra charge acts as advance compensation for the lender in the event that you default on your loan, helping it recoup its funds. There are two basic types: private mortgage insurance (PMI), imposed on conventional loans, and mortgage insurance premiums (MIP) on government-backed loans.
An origination fee is charged by a lender for initiating and processing your loan. The fee also covers the cost of underwriting the loan. In most cases, the origination fee on a mortgage amounts to between 0.5 and 1 percent of the total loan amount and must be paid at the time of closing.
PITI is an acronym for the four typical parts of a mortgage payment: principal, interest, taxes and insurance. The portion of your payment that covers principal, or the amount borrowed, and interest goes to the lender as repayment for the loan. Another portion covers property taxes and homeowners insurance premiums, and may go into an escrow account.
Borrowers can purchase discount points, aka mortgage points to lower the interest rate on their loan. Typically, one point costs 1 percent of the loan amount and lowers the rate by 0.25 percent, but there are lenders who lower the rate by more or less. The cost of points is included in the loan estimate, and the borrower pays for them at closing. In general, borrowers buy points to cut interest over the life of the loan, so buying them might only be worthwhile if the borrower stays in the home long enough to offset the upfront cost.
Preapproval is a preliminary status in applying for a mortgage, and often a key early step in the home-hunting process. It is an agreement in principle between borrower and lender, indicating the lender is willing to provide a specific amount of money to buy a home. It doesn’t mean the borrower is guaranteed a loan, but it demonstrates that the homebuyer is in a strong position to get financing (which they can demonstrate to sellers in the form of a mortgage commitment letter). Issued after a lender conducts a credit check and gathers some financial information about the borrower, preapproval generally has greater significance than a prequalification, which is essentially a faster but less-formal preapproval process.
Mortgage principal is the amount you originally borrow from the bank — the amount of your loan. Interest, by comparison, is what the bank is charging you to borrow the money. A monthly mortgage payment consists of both principal repayment and interest payments.
Private mortgage insurance
Private mortgage insurance, or PMI, is a type of coverage a borrower is required to purchase when making a down payment of less than 20 percent for a conventional loan. PMI protects the lender — not the borrower — from loss if the borrower stops making payments on the loan. When refinancing, PMI may be required if the borrower’s home equity is less than 20 percent of the property’s value.
Borrowers who already have a mortgage can refinance to a new loan with a different rate, term or both, using the new one to pay off the existing one. Borrowers don’t have to refinance with the same lender that holds their current mortgage. One common reason for refinancing is to obtain a lower interest rate, usually because economic factors have driven rates lower or the borrower’s credit has improved. Another common reason for a refinance is to shorten the loan term in order to pay off the mortgage faster and lower the total interest paid overall.
Reverse mortgages are available to homeowners who are at least 62 years old and have paid off their homes. Under this arrangement, a lender pays the homeowner each month. The homeowner is borrowing against their equity, in cash; the payments are tax-free and can be interest-free as well (that is, the borrower doesn’t have to make any payments towards it during their lifetime). Lenders are repaid when the home is eventually sold or the borrower dies.
Mortgage underwriting is the process by which a bank or mortgage lender assesses the risk they would be taking by lending to a given borrower. The underwriting process takes into account factors like the borrower’s credit report and score, income, debt and the value of the property they intend to buy. Many lenders follow standard underwriting guidelines from Fannie Mae and Freddie Mac when determining whether to approve a loan.
USDA loans (aka rural development loans) are offered to people living in rural areas. They have generous terms — they don’t require a down payment, for example — but applicants must be low- or moderate-income homebuyers. The U.S. Department of Agriculture guarantees approved homes for up to 90 percent of their loan.
All VA loans are guaranteed by the U.S. Department of Veteran Affairs. Both active duty and veteran military members are eligible to apply. VA loans are appealing to many borrowers because they don’t require a down payment.