The mortgage world can look like a bowl of alphabet soup: VHA, FHA, ARM, PMI, PITI. It can be confusing and perhaps even a little unnerving. This section will give you a basic understanding of all of the initials and help you prepare for the closing table.
From a legal standpoint, a mortgage is a voluntary lien on real estate. A borrower pledges the land to the lender as security, or collateral, for the debt. In practical terms, this means that when you borrow money to buy a piece of property, you voluntarily give the lender the right to take that property (foreclose) if you fail to repay the loan.
Tax and Insurance Reserves
When you borrow money to purchase real estate, the lender has a vested interest in how well you meet other financial obligations-in addition to repaying the loan-associated with the property. For example, if you fail to pay your property taxes and then default on your loan, the government will be paid first-and the lender will lose money on your loan. Similarly, if you fail to pay the premiums on your homeowner’s insurance and your home is destroyed by fire, your loan is no longer secured. For these reasons, many lenders require borrowers to provide a reserve fund to meet future real estate taxes and property insurance premiums. In Indiana this fund is called an escrow account. If your lender requires one, you will make the first deposit at your closing. It will cover any unpaid real estate taxes and a portion of the insurance premium liability. For the life of your loan, a portion of each mortgage payment will be allocated to paying off the principal, another portion will pay off interest, another portion will be escrowed for taxes, and the final portion will be escrowed for insurance. Your loan officer may refer to this as PITI: Principal, Interest, Taxes and Insurance.
The word amortize literally means “to kill off slowly, over time.” Most mortgage loans are amortized, meaning they are paid off slowly, over time-typically 15 or 30 years. Each amortized loan payment partially pays off both principal and interest. Each payment is applied first to the interest owed; the balance is applied to the principal. At the end of the term, the full amount of the principal and all of the interest due is reduced to zero.
For fully amortized loans, monthly payments remain consistent throughout the life of the loan. However, because the interest is paid first, the portion applied to repayment of the principal grows and interest due declines as the unpaid balance of the loan is reduced. Borrowers who make additional payments should instruct the lender to apply the additional funds toward repayment of the principal.
Conventional loans are viewed as the most secure loans because their loan-to-value (LTV) ratios are the lowest. The borrower generally makes a 20 percent down payment and borrows the remaining 80 percent of the value of the property. This is important because lenders needs to know that if a property goes into foreclosure, they can get out of it what they have invested in it.
When making a conventional loan, the lender is relying on the appraisal of the real estate (as the only security) and on the reliability of the prospective borrower as indicated in his/her credit history. No additional guarantees or insurance is necessary.
Conventional Loans and Private Mortgage Insurance
It is possible obtain a conventional loan with a lower down payment investment under the private mortgage insurance (PMI) program. PMI allows borrowers to invest less up front while still protecting the interests of the lender. If your down payment investment is less than 20 percent of the purchase price of your home, you will be required to pay at least some PMI to provide additional security on your loan. This will generally add between 5 and 10 percent to your mortgage payment.
You will not have to pay PMI for the life of the loan, however. Once you have repaid your loan to a certain level (determined by the lender), you will be allowed to terminate your coverage.
Federal Housing Administration (FHA) Loans
FHA loans are insured by the Federal Housing Administration and must be made at FHA-approved lending institutions. As with PMI, FHA insurance provides the lender with additional security against borrower default.
Certain requirements must be met before the FHA will insure your loan:
- You will be charged a percentage of the loan as a premium for the insurance. This premium may be paid up front at closing by the borrower or by a third party. It may also be financed as part of the total loan amount or paid as monthly premium. Unlike PMI, these premium payments never stop, but if the FHA doesn’t have to pay a claim, you may receive part of your money back at the end of the loan.
- FHA regulations set standards for type and construction of buildings, quality of neighborhood and credit requirements for borrowers.
- The real estate must be appraised by an approved FHA appraiser.
- The loan-to-value ratio must fall within certain limits.
FHA loans are also available for condominiums if specific requirements are met.
Veterans Affairs (VA) Loans
The Department of Veterans Affairs provides guarantees for loans for eligible veterans and their spouses. Under this program, the VA does not actually lend the money; rather, it guarantees loans made by approved institutions.
These loans are available with little or no down payments and at comparatively low interest rates.
To qualify for a VA loan, veterans must meet the following criteria:
- 90 days of active service for veterans of WWII, the Korean War, the Viet Nam war and the Persian Gulf war.
- A minimum of 181 days of active service during interconflict periods between July 26, 1947, and September 6, 1980
- Two full years of service during any peacetime period after September 7, 1980
There are limits on the amount of the loan the VA will guarantee. A lending institution may choose to extend a larger loan, but the additional funds won’t be guaranteed by the VA. To determine what portion of a mortgage loan the VA will guarantee, the veteran must apply for a certificate of eligibility. The VA also issues a certificate of reasonable value (CRV) for the property being purchased. The CRV is essentially an appraisal. If the purchase price exceeds the amount cited in the CRV, the veteran must pay the difference in cash.
At closing, veterans will have to pay a loan origination fee to the lender and a funding fee to the VA. The lender may charge additional discount points which may be paid either by the seller or the veteran.
An adjustable-rate mortgage will be originated at one rate of interest and then adjusted up or down during the life of the loan based on some objective economic indicator. Because the interest rate may change, the borrower’s monthly payment amount may also change. Details of how and when the interest rate will be adjusted are specified in the mortgage note.
Common components of an adjustable-rate mortgage include:
- The interest rate is tied to the movement of an objective economic indicator called an index.
- The interest rate is the index rate plus a premium, called the margin.
- Rate caps limit the amount the interest rate may change. Most ARMs have two types of rate caps: periodic and aggregate. A periodic rate cap limits the amount the rate may increase at any one time. An aggregate rate cap limits the amount the rate may increase over the entire life of the loan.
- A payment cap protects the borrower by setting a maximum amount for the payments. The downside is that this can result in negative amortization where the loan balance is actually increasing over time.
Your lender may want to sell your loan to investors. To make the sale more attractive to the investors, the lender may charge you “discount points.” A point equals one percent of the amount being borrowed. So, if you are borrowing $100,000 and the mortgage company you are considering will charge you three discount points, that’s an additional $3000. Sometimes this amount is financed as part of the total loan amount, and sometimes it must be paid in cash at closing. Before you finalize your financing, be sure you understand the lender’s requirements.
If you repay your loan before the end of the specified term, your lender will not collect as much interest/profit as anticipated. For this reason, some mortgage notes contain a prepayment clause which requires the borrower to pay a penalty on any payments made ahead of schedule. Ask potential lenders about prepayment penalties before finalizing your financing. Lenders can not charge prepayment penalties on mortgage loans insured or guaranteed by the federal government.