Financial Terms Every Homebuyer Should Understand When Applying For a Mortgage
Buying a home is one of the biggest financial commitments that you will make in your life, if not the biggest. If you have read through our blog, you know that this is the case – we talk about it a lot. We have mentioned in most of our other posts about mortgages, the financial commitment of a mortgage can last decades and cost several years’ worth of income. This is intimidating for many people, and it is all the more intimidating for first-time homebuyers. Finding the perfect home, striking a great deal on price, landing an optimal mortgage, and coordinating moving logistics can be a major headache, and many people get discouraged just by the idea of facing all of those things.
We wrote a post in the past on tips for first time homebuyers, and this post ties in to that with some of the terms that we think every homebuyer should understand when applying for their mortgage. Not everyone has a finance degree, and the terms that get thrown around during mortgage conversations with lenders can be very daunting and intimidating. This post is for those people who may be apprehensive about buying their first home, specifically because of all the work that goes into getting your mortgage. If you do your homework and go into the talks with the right mindset, you can certainly strike a great deal. However, if you go in thinking the bank has your own best interests at heart, you may not get the best terms available. Here are some terms that you should know.
First, Financial Concerns About Buying Your First House
Talking about mortgage terms is very relevant, as the financial component of buying a house is often the biggest deterrent or anxiety causing part of the process for new homebuyers. After all, it is the part that will affect your lifestyle the most. Most first-time homebuyers are in their early and middle phases of life, where signing a 30-year loan seems like an eternity. For someone in their 20’s, this means potentially agreeing on a loan that will be longer in length than their entire life up to that point! It is perfectly normal and natural to worry about finances when shopping for a new house for the first time. After all, your mortgage payment will probably equate to anywhere from a quarter to a half of your income each month.
Luckily, there are many resources available to help you navigate the financial nuances of the homebuying process. We have actually written several posts that could be of use to you, and this one falls into that category as well. In all of our posts, our goal is to help you out and alleviate as best we can any concerns or fears you have about the homebuying process, and we hope that this post, as well as the others we have written, prove to be useful for you throughout this long and exciting process.
1. Interest
Most adults have heard the word interest, but some don’t fully understand what it is. That is okay! You can’t be expected to know financial terms if you haven’t dealt with large loans or financial commitments before. Interest is, however, one of the most crucial concepts to understand when taking out a mortgage, as it makes up a huge chunk of the money that you will pay to the bank over the next couple of decades.
It costs a bank money when they give you a loan. Not only do they need to give you the thousands of dollars when you take out the loan, but they also need to consider all of the investments that they could have used that money for if they hadn’t given it to you. The way that they make back this missed investment income is by charging interest, which is basically a fee for letting you use their money. The interest rate is the percent of extra money you will pay the bank on top of the loan amount. If you take out a loan for $300,000 at 2% interest, you might pay (this is a simplification, for understanding purposes) around $6,000 extra of interest. In the real world, this number winds up being much higher, and it could very easily be in the tens of thousands of dollars. Therefore, the lower the interest rate, the better!
2. Mortgage Term or Loan Term
The loan term, or mortgage term, is the total amount of time that your loan will be active and in issuance. This is one of the key things that you agree on during the mortgage negotiations. Mortgages are typically 30-year commitments, but mortgage terms can vary and even be as short as 10 years. The loan term is important, as it is a key factor in determining your monthly payment. Shorter mortgages mean higher monthly payments, but less total interest paid over time. Longer mortgages mean lower monthly payments, but more total interest paid over time. The mortgage term can also have an effect on your down payment, as lenders have ratios and requirements that they need to meet when handing out hundreds of thousands of dollars of cash.
3. Loan-to-Value Ratio
Your loan-to-value ratio, also known as your LTV, is the ratio between your total loan amount and
the total price of the home you are purchasing. For example, if you apply for a $150,000 loan to purchase a house that costs $200,000, your loan-to-value ratio is 75%, as $150,000 divided by $200,000 is 75%. In this case, the other $50,000 that is required to purchase the house would be covered by the down payment. There is flexibility, but a typical LTV is about 80% or less. Really, with all of these ratios there is plenty of flexibility, as the bank is just looking to make sure it adheres to banking laws and approves loans to people who will be able to pay them off. If that is you, you will probably be fine!
4. Loan Principal
The principal is the total stated amount of money that you are borrowing. This can also be referred to as the financed amount. This is the amount of money the bank gives you to purchase your home, and does not include any kind of interest or other fees. Those things are what you will repay the bank in addition to the principal over the lifespan of your mortgage. Paying off the principal is what causes you to gain equity in your home, meaning that any extra principal you can pay off each month means less interest that you eventually need to pay!
How exactly does that work, you might ask? It’s very simple. Your principal is the amount of actual money that the mortgage lender is giving you. The interest is just what you are paying them back as a convenience fee. So, paying off interest doesn’t actually earn you any more equity in your home, as the equity is directly tied to the principal. As you pay of the principal, you directly gain equity in your home. Paying ahead on your mortgage, if you’re allowed, helps you to avoid paying interest while getting more equity in your home, sooner.
5. Closing
Closing is the phase of the homebuying process when you meet in person to finalize all of your closing documents. These include the paperwork stating the mortgage terms, including the interest rate, monthly payments, and other costs involved in the issuance of the mortgage. At closing, all of the documents are signed and it becomes official – you are a homeowner! This is the last chance you have to back out before things become official and locked in. Don’t worry, this time should not be filled with worries, but rather excitement! At the end of the day, as long as the paperwork is right and you have a good realtor, the only thing you need to worry about is bringing your favorite color pen and a lanyard for your new set of keys!
6. Down Payment
The down payment is the amount of money that you pay to the bank on the day that you sign the loan. It is the amount that you both agree upon that will be paid before any money is given to you in the form of a mortgage. Depending on the price of the house, the expected down payment can be very different. The down payments often falls anywhere from 5% to 20%, but can be more depending on the terms of your mortgage. It is even possible to pay absolutely nothing as a down payment, but this often leads to significantly higher monthly payments. The down
payment takes care of the difference between your total mortgage amount and the purchase
price that you agree upon with the seller. Typically, paying a higher down payment means that your monthly payments will be less, but not everyone can afford to pay a very large down payment!
7. Closing Costs
Closing costs are the different monetary amounts you need to pay while at closing. This can refer to a whole slew of things, but most often refers to insurance, legal paperwork, lawyer fees, appraisals, and any other costs that are accrued throughout the homebuying process. You pay the closing costs at the time of closing, and they generally cost about 3% of the total mortgage amount. Your realtor will make sure that you are prepared for this, so there really should not be any surprises. Don’t worry about that – here at the Boyd Team we have you covered.
8. Annual Percentage Rate
The annual percentage rate, also known as the APR, shows you the total cost of the loan in addition to the principal. This includes factors like interest, fees, closing costs, insurance charges, and other miscellaneous incidentals that pop up through the homebuying process. It differs from the interest rate as it includes other costs that bring up the total amount of money that you are paying. The APR is a more accurate representation of what you will be paying than the interest rate, as homebuyers frequently forget to include many of the incidental costs in their calculations.
9. Private Mortgage Insurance
The typical mortgage term is 15 or 30 years, and buyers typically make a lump payment at the beginning of the mortgage term to use as collateral for the loan. While this is appealing to the bank, it still does not guarantee that the buyer will be able to finish out the loan payments for 30 years, and it is not extremely uncommon that buyers default on their mortgage part of the way through the mortgage term. For this reason, many mortgage lenders may require buyers to have private mortgage insurance. This insurance reimburses the bank in the incident where the buyer is no longer able to make the necessary payments to finish out the loan term. While
the required down payment may vary based on loan conditions, down payments less than 20% require the buyer to get their own private mortgage insurance.
10. Debt-to-Income Ratio
The debt-to-income ratio is one of the most important ratios that your mortgage lender considers when determining the conditions of your mortgage. The debt-to-income ratio measures exactly what it looks like; it compares how much money you owe to other institutions against how much money you make as income. This is calculated by dividing your monthly debt payments by your gross monthly income, which is all of the money that you make before tax. These debts could include credit card balances, car payments, student loan payments, big medical bills, and many other things. Debt-to-income ratio is shown as a percentage, and your monthly mortgage payments should be right around 25-35% of your gross monthly income.
11. Escrow Funds
Escrow funds are the funds that you pay to a third party for holding. These funds are held by the third party until a specific condition or date occurs. Your down payment or deposit may be placed in escrow, for example, until all of the paperwork for the mortgage is complete and the deal for the home goes through. Escrow is used for financial transactions all the time, and is not specific to just the real estate industry. Using escrow as a payment intermediary makes your transaction safer, as the money cannot be removed from escrow until both parties have fulfilled their side of the bargain. If the mortgage lender or the seller backs out, you get your money back, and there is no way for the bank to try to take it. In addition to your down payment, mortgage lenders might require a percentage of yearly taxes to be held in an escrow account to guarantee that you will pay them.
12. Interest Rate Lock
We have already explained the concept of interest, but what we did not divulge is that interest rates change all of the time. From day to day, interest rates jump around small amounts, and these small interest rate changes can mean drastic differences in the total amount of money that you pay for your home. Interest rate lock is when the buyer and lender agree on the terms to a mortgage and lock in the interest rate for a set period of time, keeping it from fluctuating in the coming days while the rest of the paperwork gets settled and the closing occurs.
Thanks for reading our post about the mortgage terms that every homebuyer should know. We know that buying a home is intimidating and the mortgage is often one of the most daunting parts. If you go into the negotiation room prepared, this can be a much less intimidating part of the homebuying process, and it can ultimately save you thousands of dollars. If you go into the negotiation room thinking that the mortgage lender will have your best interests at heart, you will probably get a bad deal. Knowing the vocabulary that we have presented in this post at least will make you more ready to understand what it going on and speak for yourself and your own interests!
If you visit Myrtle Beach or any other place in South Carolina and fall in love, we’re here to help. We at The Boyd Team are committed to helping you find the right property for your needs and dreams. Any question that you have about moving to the area and finding your dream home by the beach is our pleasure to answer. Feel free to send us an email at eddie@boydteam.com or text or call us at (843) 222-8566, and we will get back to you as soon as we can. Being true natives of the Grand Strand and Horry County and with over 25 years of experience in the local real estate market, whether buying or selling, we can help you make your dreams a reality.
No One Knows The Grand Strand Better! Trust, Knowledge, Experience, Professionalism, You Can Count On!
Written by Greg
