How Does Refinancing Work (And When It Makes Sense)
It’s understandable to feel intimidated when buying a home for the first time. After all, you’re likely making a six-figure purchase and encountering terms you may have never seen before.
If you’re looking for mortgage definitions in plain English, you’re in the right place. We’ve developed this guide to answer common questions so you can navigate the homebuying experience with confidence.
In this article
- 11 key mortgage terms to know
- What is a mortgage?
- What types of mortgages are available?
- What should you do before you apply for a mortgage?
- How does the mortgage application process work?
- What should you expect at the real estate closing?
- Bottom line
11 key mortgage terms to know
You may see the terms below on disclosure documents or hear your lender mention them when applying for a mortgage. If you have mortgage questions, this list should help.
Amortization is a fancy word that simply describes what happens to your mortgage balance as you make payments. An amortization table outlines your repayment schedule and shows how your balance will decrease over the loan term, providing you make payments as planned.
It also shows how your payment structure can change over time. At the beginning of your loan term, a higher percentage of your payments will go toward interest. And as you pay down your loan over time, more of your monthly payment will go toward the principal.
An appraisal is a process where an appraiser determines the value of the home that you’re buying. Lenders usually order an appraisal because they want to know how much a home is worth before offering a borrower a loan to buy it. If the home appraisal comes in too low, you may have to negotiate a new sale price with the seller or come up with the cash to cover the difference. Otherwise, the lender could back out of the deal.
APR stands for annual percentage rate and is a percentage the lender charges to borrow money on a yearly basis. This percentage includes interest, fees, and any other additional charges. You may notice that your interest rate is different from your APR. That’s because the APR percentage includes fees and an interest rate does not.
Closing costs are costs that you have to pay to process the mortgage and real estate transaction. Closing costs may include taxes, title insurance, appraisal fees, origination fees, and more.
Homebuyers are typically on the hook for paying the closing costs, but in some cases, you may be able to negotiate for the home seller to help foot part of the bill. Generally, closing costs are 2% to 5% of the loan.
Debt-to-income ratio (DTI)
Your debt-to-income (DTI) ratio is one of the most important factors (aside from your credit) that lenders consider when determining if you qualify for a mortgage. There are two DTI ratios — the front-end and back-end DTI.
- Front-end DTI is calculated by dividing the monthly housing payment alone by your monthly income and then multiplying by 100 to get a percentage.
- Back-end DTI is calculated by dividing the sum of all your monthly debt payments by your monthly income and then multiplying by 100.
DTI requirements can vary by lender and loan type, but generally, you need a back-end DTI below 43% to qualify for a conventional mortgage (more on what a conventional loan is in a second). That said, having a lower DTI may increase your approval odds.
Your down payment is the amount of money you’re putting down on a home. Some lenders may require a down payment of 20% of the purchase price, so if you’re buying a house for $350,000, you would need to put down $70,000.
However, many mortgage options let you put down less than 20%. For example, 3% down may be accepted for certain conventional loans, and you could put down as little as 3.5% on an FHA loan.
Escrow is an account managed by a third party that’s used to hold and transfer funds. There are two types of escrow accounts this term can refer to.
During the homebuying process, earnest money that you give a seller upfront to express interest in a home may be held in an escrow account. Then, when the deal goes through, that earnest money may get added to your down payment.
After you purchase the home, an escrow account may also be used to hold your payments for property taxes and homeowners insurance until they’re due.
Points can mean something different from one lender to the next, so it’s a good idea to clarify what it means as you shop around. In general, lenders may call lender fees mortgage points. Lenders could also be referring to “discount points” when talking about points. Discount points are percentage points you purchase upfront to lower your mortgage interest rate.
The loan principal is the amount you initially borrow to purchase your home. When you make mortgage payments, part of your payment typically goes to paying down the principal balance, and another part goes to interest and escrow to pay for insurance, taxes, and other costs.
Private mortgage insurance
Private mortgage insurance (or PMI) is insurance you may be required to pay if you put less than 20% down on a conventional loan. PMI may be paid monthly, upfront, or a combination of both. Lenders charge PMI if you put less than 20% down because it helps protect them if you default.
Title search and insurance
A title search is typically performed during the homebuying process to ensure that the seller has a right to sell the home and that there are no liens on the property. After the search, the title company may offer title insurance, which protects you if someone brings up a claim against the property after you buy it. The cost of the title search and insurance is often included in the closing costs.
What is a mortgage?
Now that we’ve covered some of the most common mortgage-related terms, let’s dig into what a mortgage actually is. A mortgage loan is a lump sum that lenders offer to let you purchase a home. When you enter a mortgage agreement with a lender, a lien is put on the property, which means the lender can foreclose on your home if you don’t make payments.
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You can get mortgage financing from banks, credit unions, and online lenders. To qualify, lenders typically pull your credit to determine how much of a credit risk you are, and they ask for information about your finances to make sure you can afford the loan.
What types of mortgages are available?
In the world of mortgages, there is no lack of options. Here’s a breakdown of some of the most common loan types:
A conventional mortgage is one that’s not backed by a special government program. Conventional mortgages can be conforming or non-conforming. Conforming loans fall under certain limits — up to $548,250 in most areas for a single-family home or $822,375 in high-cost areas — and can be sold to Fannie Mae and Freddie Mac. Non-conforming loans exceed those limits.
Putting 20% of the home price down on a conventional loan is customary, but some loan programs accept as little as 3% down. The maximum DTI you may be able to have for a conventional mortgage is 43%, but that requirement might also vary.
Here are a few types of conventional loans:
- Fixed-rate mortgage: A fixed-rate conventional mortgage has a fixed interest rate for the life of the loan.
- Adjustable-rate mortgage (ARM): An adjustable-rate conventional mortgage is one where the interest rate may change after a set period of time to follow a market index.
- Jumbo loan: Jumbo loans offer a higher loan amount than the loan limits set by Fannie Mae or Freddie Mac for conforming mortgages. Credit, income, and DTI requirements can be stricter for jumbo loans since you’re borrowing a large sum.
Government-backed mortgages are loans where the government insures the loan in case you default. This insurance backing minimizes risk for lenders, which results in some more flexible eligibility requirements. Minimum credit scores and DTI limits can vary for government-backed loans.
Here are three options:
- FHA loan: FHA loans are backed by the Federal Housing Administration and are a popular mortgage for first-time homebuyers because down payment requirements can be low, sometimes just 3.5% to 10%. However, borrowers will need to pay mortgage insurance premiums with an FHA loan. These loans can have either fixed or adjustable rates, and you might also be able to qualify with a credit score below 600.
- VA loan: VA loans are backed by the Department of Veterans Affairs. These loans are for qualifying veterans, active-duty service members, and surviving spouses. They may require no down payment, and the loan program has no minimum credit requirement. Veteran home loans can be either fixed- or adjustable-rate.
- USDA loans: USDA loans may also offer 100% financing for eligible homebuyers in certain rural areas. The program doesn’t have a minimum credit score requirement either, though all loans are 30-year fixed-rate.
What should you do before you apply for a mortgage?
If you’re thinking about buying a new home, here are a few steps to consider taking before applying for a mortgage:
- Check your credit report: Your credit report and score can affect your approval odds and interest rate when applying for a mortgage. Coming up with a plan to improve your score could help you get approved for a loan with competitive rates and fees.
- Explore loan options: Do a preliminary home loan search to get a general sense of what home loan types could be best for you. For example, if you’re a qualifying veteran or active-duty servicemember, the VA loan could be on your shortlist of loans to consider.
- Save for a down payment: After determining what down payment you might need for the loan types you’re considering, start saving. Consider setting up an automatic transfer of funds each month from checking to a “new house” savings fund.
- Get pre-approved: When you’re ready to start home shopping, getting pre-approved for a mortgage is a good first step. A pre-approval letter tells you how much you’re conditionally approved for, which can help you determine your homebuying budget.
How does the mortgage application process work?
As mentioned briefly above, getting pre-approved is a good first step in the mortgage process. In the pre-approval application, you tell a lender information about your finances, and a credit check is performed to give you a conditional offer. The offer includes how much money the lender might be willing to let you borrow, pending a more thorough review of your application.
After your offer on a home is accepted, the lender will generally verify documents — such as pay stubs, W-2s, tax returns, bank statements, investment account statements, and more — to confirm the information on your application. You’ll also receive loan disclosures that outline the cost, monthly payments, and other terms of the loan you’re applying for.
Your lender typically orders an appraisal at some point to determine the value of the home. If the appraisal comes in too low, you might have to renegotiate the sales price with the seller or come up with the difference in cash, or the lender could pull out of the deal. Understandably, lenders are leery of lending a homebuyer more money for a home than its appraised value. If the appraisal goes well and your loan application makes it through underwriting, you’ll generally receive the Closing Disclosure and move to the closing stage.
What should you expect at the real estate closing?
The real estate closing process is when you sign final loan documents, hand over the necessary funds, and take over ownership of a home.
How closing happens can vary depending on where you live and lender requirements. In some cases, you might meet at a location with multiple parties, such as your agent, representatives from the title insurance company and escrow company, and the seller’s attorney. In some cases, you may be able to handle the signature process online.
What do you need to get a mortgage?
At the most basic level, you generally need forms of identification, proof of income, decent credit, tax returns, and some savings to get a mortgage. Exactly how much savings and what documents you need can vary.
A lender may ask you to provide several years of financial statements to calculate your income if you’re self-employed. If you’re employed by a company, you may need to provide the address and phone number of the company for verification along with pay stubs or W-2s.
As for credit score requirements, you’ll likely need a credit score of 620 to qualify for a conventional mortgage. But you may be able to qualify for government-backed loans, such as FHA and VA loans, with a credit score that’s lower than 620.
How much money should you save for a down payment?
How much you should save for a down payment depends on the type of loan you plan to apply for and whether you prefer to pay less money upfront or pay less money over time. While many loans might accept a low down payment, putting down a small amount could increase your monthly mortgage payment and cost you more in the long run. This is why deciding how much to save up for your home is something to consider carefully.
Putting the full 20% down on a conventional mortgage could help you avoid paying monthly PMI. If that’s not possible at the moment, saving up 3% to 15% of the home price might be enough to qualify for a conventional loan if you have strong credit. For VA and USDA loans, you may not need to save for a down payment at all since 100% financing might be available.
Can you pay off a mortgage early?
Yes, you can pay off your mortgage early, but you could run into prepayment penalty fees depending on how early and which type of loan you have. FHA, VA, and USDA loans don’t have prepayment fees, but other mortgages might have early pay-off fees. Read the fine print or talk with a loan officer to find out if there is a fee and when it’s charged.
Most of us don’t have a few hundred grand to throw down on a property, especially not for a first house. Mortgages make homeownership possible for people who can’t make a cash offer.
The process of how to get a loan can be confusing the first time around, but it’s fairly straightforward once you understand it. Comparing multiple loan options can help you find the right loan for your home purchase, and DadeLoan’s best mortgage lenders roundup is a good place to start your search.
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