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Understanding mortgage terminology like APR, points and preapproval is essential when comparing home loans, 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 terms you’re likely to encounter as you shop for a mortgage.
15 common mortgage terms
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, or 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.
Closing costs are the upfront 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, title search fee and others. Closings costs are generally paid by homebuyers, but sellers may cover some of the costs in certain situations.
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, but there is some flexibility with that figure.
The down payment is the amount of a home’s purchase price a homebuyer pays upfront. Buyers typically put down a percentage of the home’s value as the down payment, 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 agreement for a home, generally as a sign of good-faith intent. The deposit is typically held by the 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 agreement.
An escrow account — also called an impound account — is an account that holds the portion of a borrower’s monthly mortgage payment that covers 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, 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.
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 private 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.
PITI is an acronym for the four 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 or 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.
A preapproval letter from a bank or mortgage lender indicates that the lender is willing to lend a borrower a specific amount of money to buy a home. It’s usually issued after a lender conducts a credit check and gathers some financial information about the borrower. Preapproval doesn’t mean the borrower is guaranteed a loan, but the letter can be given to a seller to demonstrate that the homebuyer is in a strong position to get financing. Preapproval generally has greater significance than a prequalification, which is essentially a faster but less-formal preapproval process.
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.
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.