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MORTGAGE & FINANCING TERMS

Adjustable-rate mortgage
Adjustable rate mortgages are called ARMs for short. The lender changes the interest rate periodically in accordance with the loan agreement. For example, the loan agreement may say that the rate on a 1-year ARM is reset every Sept. 1 after an initial period of three years. The interest rate is calculated by adding a margin to an index rate. If the margin is 3 percentage points and the yield on the 1-year bill (assumed to be the index rate) is 6%, the loan rate is reset to 9%. ARM loans usually have provisions that limit how much the loan rate can increase at one resetting and over the term of the loan.
Adjustment period
The adjustment period is the frequency that the lender adjusts the interest rate on a variable-rate mortgage loan. For example, a 1-year ARM would have an adjustment period of one year.

Aggressive qualification estimate
Mortgage lenders are more aggressive when the economy is strong. As a result, they tend to lower their loan-qualification requirements to make it easier to qualify for loan.

Amortization
Amortization is the gradual reduction of loan principal that occurs as you make periodic loan payments. Generally, the loan principal is completely amortized with the final payment. As you pay back the loan, an increasing amount of each payment is applied to principal and a lesser amount is applied to interest. Amortization is also a process of spreading a cost that is incurred upfront over the term of the loan or life of the asset.

Amortization table
Table of factors that shows how loan principal is repaid based on the interest rate and loan term.
Anniversary date
Anniversary date is the periodic date, usually once a year, that the interest rate is reset on an adjustable-rate mortgage.
Annual percentage rate (APR)
The real cost that you pay to borrow, stated as a yearly percentage of the loan amount. This is sometimes called your effective borrowing cost. For auto and mortgage loans, closing costs and discount points are added to calculate APR. For example, if you pay $500 in closing costs to obtain a $10,000 loan, the APR will be higher than the interest rate since you are effectively borrowing $9,500 but will owe $10,000. The Truth-in-Lending Act requires the lender to disclose the APR to you. For credit cards, the annual fee is often not included in the APR calculation. As a result, an APR of a credit card is often its simple interest rate.

Appraisal value
Appraisal value is the market value of an asset that is derived from the appraisal process. Depending on the asset, the method used to appraise the asset will differ. For homes, appraisers often use a method that includes recent sales data of comparable homes. They may also use the replacement method, which is the cost to replace the home at today's prices.
Appreciation rate
Appreciation rate is the yearly percentage rate that an asset increases in value. For example, a home that you paid $150,000 three years ago that is almost worth $200,000 today had an average appreciation rate of 10%. After the first year, the home was worth $165,000. After the second year, the home was worth $181,500. And after the third year, the home is worth just a little under $200,000.

Base rate
The interest rate that is used as a benchmark to set the interest rate for borrowers. A base rate is sometimes called an index rate. For example, if you obtain a one-year adjustable-rate mortgage, your loan rate will be reset once a year to a rate that equals the loan rate plus a margin. Interest rates on credit cards are frequently tied to a change in the prime rate, another popular base rate used in consumer lending.

Closing costs
Closing costs are the total expenses that the buyer pays at the time a real estate transaction is completed. This stage of the transaction is called "closing." Closing costs include application, underwriting and loan-origination fees; mortgage points; title search and insurance; fees for related legal services; and costs to fund an escrow account. For home mortgage loans, closing costs generally range between 3 and 6 percent of the home purchase price.

Conservative qualification estimate
Mortgage lenders are more conservative when the economy is weak. As a result, they tend to raise their loan-qualification requirements to make it more difficult to qualify for loan.

Cost analysis
An analysis that subtracts the benefits of homeownership from the costs of homeownership to obtain a net cost. Included in costs are mortgage interest, discount points, closing costs, property taxes and homeowner's insurance, home maintenance costs, and any private mortgage insurance (PMI). Included in benefits are the tax savings on deductions for mortgage interest (including points) and property taxes, and an increase in equity that you receive either from repayment of the loan principal or an appreciation in the value of your home.

Debt ratio
Lenders use a debt ratio (also called debt-income ratio) to approve loan applicants. Debt ratio equals combined monthly debt payments divided by gross monthly income. For example, combined monthly debt payments of $2,000 divided by gross monthly income of $4,000 equals a debt ratio of 50%.

Down payment
A down payment is the cash you deposit towards the purchase of a home, business property, or vehicle. The larger the down payment, the less you need to borrow. For home loans, a down payment of 20% of the home purchase price is generally required to avoid private mortgage insurance. The value of a trade-in vehicle is often used instead of a down payment for purchasing a vehicle.

Equity
The residual ownership claim on a home's value. Equity equals the fair market value of a home, less any mortgage debt or other obligations.

Homeowner's insurance
Also called property insurance, homeowner's insurance protects the homeowner from weather-related damage, as well as potential liability from events that occur on the property. Lenders require homeowner's insurance coverage to protect the collateral that secures their loan. Some homeowner's insurance policies do not cover catastrophic events such as tornadoes, hurricanes or floods. These kinds of events generally require a separate insurance policy.

Housing ratio
Lenders use housing ratio to approve loan applicants. Housing ratio equals combined monthly mortgage payment divided by gross monthly income. For example, a combined monthly mortgage payment of $1,500 divided by gross monthly income of $4,500 equals a housing ratio of 33%.

Impounds for taxes and insurance
Impounds are payments that you make in advance for homeowner's insurance premiums and real estate taxes. You make these payments to an escrow account at loan closing, and periodically replenish the account. An escrow agent pays the local tax authority and insurer from this account. Analyzers calculate impounds for two months. Local lending requirements on funding the escrow account vary.

Index rate
An index rate is a widely used interest rate that lenders use to set the interest rate on loans and credit cards. For residential mortgages, 10-year U.S. Treasury securities are often used for 30-year fixed-rate loans (on average, most homeowners live in their homes for a period of time closer to 10 years than 30 years). For ARM loans, a common index is the Eleventh District Cost of Funds Index (COFI), published by the San Francisco-based district office of the Federal Home Loan Bank. For credit cards, the U.S. commercial prime rate is frequently used as an index rate.

Initial interest rate
The starting interest rate on an adjustable-rate mortgage loan, which is often below market ARM rates. The intent of a low initial rate is to assist homebuyers that may not otherwise qualify for a mortgage loan.

Interest-only mortgage payments
Mortgage payments that include only interest. No loan amortization occurs and, thus, the homeowner does not accrue any equity (unless the home value increases).

Interest rate cap
A limit on the amount the interest rate can increase. A periodic cap limits how much the rate can increase at each adjustment period. A lifetime cap limits how much the rate can increase during the term of the loan.

Lifetime cap
A lifetime cap is the limit to how much the interest rate on an adjustable-rate loan can be increased over the term of the loan.

Loan-to-value (LTV) ratio
Loan-to-value ratio is a key factor in determining how much of a home you can qualify for. To calculate, divide the mortgage loan amount by the fair market of the home value. A recent appraisal is generally required to determine fair market value. If you have existing mortgage debt or are adding debt, divide the combined mortgage balance by the home value. For example, a mortgage loan of $150,000 on a home that is appraised at $200,000 has an LTV of 75%. As a general rule, mortgage loans that exceed an LTV of 80% require private mortgage insurance.

Loan qualification estimates: aggressive versus conservative
Lenders ease their loan-underwriting guides when economic times are good. This environment leads to more competition among lenders for qualified borrowers. Thus, lenders become more aggressive in making loans. When economic times are worse, lenders rein the amounts they are willing to lend. Thus, lenders become more conservative.

Margin
Margin has different meanings for different industries. For mortgage lending, margin is the amount a lender adds to the base rate of an adjustable-rate mortgage or other variable-rate loan to set the loan rate. For example, if a one-year ARM loan has a margin of 300 basis points over the yield on 1-year Treasury bills and the T-bill yield is 6.5%, the loan rate is set to 9.5%. For brokerage accounts, margin is the deposit required by an investor who short-sells a stock (i.e., borrows shares from a broker and sells the shares, hoping to buy them back at a lower price and return the borrowed shares.)

Mortgage points
Mortgage points are also called discount points, points, loan discount points, loan origination fees or maximum loan charges. A point is equal to 1 percent of the loan amount. For example, 1 point on a loan of $150,000 equals $1,500. Lenders consider mortgage points as interest that you pay in advance. As a result, the more points you pay when you close the loan, the lower your interest rate. If you qualify, you may be able to deduct mortgage points in the year you close the loan for tax purposes. Otherwise, you will have to amortize the points paid over the term of the loan.

Negative amortization
This is a phenomenon in home lending which occurs when a payment cap restricts the repayment to an amount less than the payment necessary to reduce the principal balance. This has the effect of increasing the loan amount.

Origination fee
A lender may charge an origination fee that is additional to any mortgage points you pay. Origination fees are the lender's charge for funding your mortgage with a mortgage broker. The process of funding your loan is called origination.

P+I
P+I is an acronym for loan principal and interest that you pay on an amortizing loan, including mortgage loans. If your mortgage loan payments include property taxes and homeowner's insurance, the monthly payment amount is referred to as P+I+T+I.

P+I+T+I
P+I+T+I is an acronym for loan principal, interest, property taxes and homeowner's insurance.

Payment cap
A limit on the amount that the monthly payment can increase. A periodic cap limits the amount of the increase at each adjustment period. A lifetime cap limits the amount that the monthly payment can increase during the term of the loan. A potential peril of payment caps is negative amortization. In the case of an adjustable-rate mortgage with a payment cap, rising interest rates may cause the loan payment to be insufficient to cover even the interest portion of the scheduled payment. In this case, the unpaid interest may be added to the mortgage loan principal, if the loan agreement permits.

Periodic rate cap
The periodic interest rate cap is the maximum amount the loan rate can change on an adjustable-rate mortgage loan on the anniversary date. ARM loan rates are often reset once a year after an initial period. A lifetime cap often exists. A lifetime cap limits the maximum loan rate that can be charged.

Prepaid interest
Prepaid interest is the interest that you pay the lender in advance, often when you close on a loan. If you close a loan before the end of the month, the lender will require you to pay interest for the number of days until the end of the month. This is one form of prepaid interest. Analyzers that calculate prepaid interest assume the loan closing date is the midpoint of a 30-day month. As a result, prepaid interest is calculated for 15 days. The IRS recognizes points that you pay at loan closing as prepaid interest. One point equals 1% of the loan amount. If you meet a checklist of requirements, the IRS allows you to deduct these points in the first year of your mortgage loan.

Private mortgage insurance (PMI)
Private mortgage insurance is an insurance policy that a residential mortgage lender requires of the borrower if the loan-to-value (LTV) ratio of the home is greater than 80%. Mortgage insurance protects the lender from the risk that the borrower may default on the loan. Federal law requires lenders to notify borrowers when the loan-to-value ratio drops below 80%. Mortgage insurance premiums vary, but generally range from $1,000 to $5,000 a year for an average priced home.

Property taxes
Property taxes are also called real estate taxes. These taxes are paid to the local taxing authority or municipality. The amount you pay can generally be deducted from your federal income taxes. Property taxes are often levied as a percentage of your home's assessed value. For example, if you pay 0.5% in property taxes of the assessed value, a home assessed at $250,000 would have a yearly property tax bill of $1,250.

Savings interest rate
The savings interest rate is the yearly interest rate you earn on your savings. It is also used to calculate the opportunity cost of paying with cash. In contrast, the saving rate is the percentage of income you save.

Tax rates
The Economic Growth and Tax Relief Reconciliation Act of 2001 cuts individual income tax rates for all brackets except the 15% rate. A sixth tax bracket of 10% was also added for the first $6,000 of income for single taxpayers, $10,000 for single parents, and $12,000 for married taxpayers. All rates except the 15% rate (and new 10% rate) were cut by one-half percentage point on July 1, 2001. As a result, tax rates for all of 2001 are 10%, 15%, 27.5%, 30.5%, 35.5%, and 39.1%. For 2002, rates drop to 27%, 30%, 35%, and 38.6%.

Tax savings
Tax savings are the amount you may save in taxes from a tax deduction or credit that you would otherwise pay if you did not have the deduction or credit. Tax savings are also called a tax shield. To calculate tax savings from a deduction, multiply the amount of the deduction by your marginal income tax rate. At an income tax rate of 27%, a $2,000 qualified contribution to a company retirement plan may save you $560 in taxes. And if you paid $10,000 in home mortgage interest, you may save up to $2,700 in income taxes if you are in the same tax bracket. Your deduction for interest expense on mortgage and home equity debt may be limited. You may wish to consult a financial or tax adviser. For businesses, tax savings are realized on such deductible expenses as lease payments, interest on loan payments, and depreciation expense.

Tax shield
Tax shield is the amount of taxes you may save from a tax deduction or tax credit that you would otherwise pay without the deduction or credit. To calculate tax savings from a deduction, multiply the amount of the deduction by your marginal income tax rate. At a marginal income tax rate of 27%, a $2,000 qualified contribution to a company retirement plan may save you $560 in taxes. And if you paid $10,000 in home mortgage interest, you may save up to $2,700 in income taxes if you are in the same tax bracket. Your deduction for interest expense on mortgage and home equity debt may be limited. You may wish to consult a financial or tax adviser. For businesses, tax savings are realized on such deductible expenses as lease payments, interest on loan payments, and depreciation expense.

Term
The period of a loan, generally measured in years. Auto loans: generally range between two and five years. Mortgage loans: generally 15 or 30 years.

Underwriting
Underwriting means different things to different financial-services industries. For mortgage lenders, it is the process of evaluating a loan prospect to see if they have the financial capacity to repay the loan. For investment bankers, it is the process of arranging a sale of stocks or bonds to investors. For insurance companies, it is the process of calculating a premium for a specific pool of insurers with certain risk characteristics such as age or health.

Yield
Yield measures the investment return of a bond and is calculated in three major ways: current yield, yield-to-maturity and yield-to-call. Current yield is the bond coupon rate divided by current price. It is an expedient but incomplete method for calculating yield. Yield-to-maturity (YTM) is the expected yield an investor earns for holding a bond to maturity. YTM includes coupon income and any premium or discount the investor pays. Yield-to-call is the expected yield an investor earns if the bond is held until its first call date, when it is assumed to be called by the company that issued the bonds. Difference in bond yields is called the yield spread or credit spread. Yield spread measures the extra yield a bond must pay to compensate for additional risk over a risk-free bond. For example, if a 10-year corporate bond earns a yield of 6.25% and a 10-year U.S. Treasury bond yields 5.75%, the yield spread is 50 basis points.

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Last modified: 02/06/09