What is a Mortgage?
When people want to buy something now, but don’t have (or don’t wish to spend) the cash to buy it outright, they can instead use a loan (aka financing, borrowing, debt). This typically involves an agreement between the consumer and a lender. The lender provides the big chunk of money today (that big amount that the consumer didn’t want to, or couldn’t spend) and the consumer agrees to make payments back to the lender over time. An example of this that almost everyone will be familiar with is auto financing (i.e. car payments).
A mortgage is simply the financing of a home.
Like an auto loan, a mortgage allows the consumer to legally own the underlying asset (car, home). Like auto loan paperwork, mortgage paperwork allows the lender to take back or “repossess” the underlying asset (aka “collateral”) if the consumer doesn’t pay as agreed, although the process is much more complex and time consuming. The idea is that if a consumer isn’t willing or able to honor the agreement, the lender can recoup some or all of their initial investment by taking the collateral (i.e. home, car) back and selling it.
What’s in it for the Lender?
Lenders don’t tend to lend money simply because consumers want loans. Lenders make money by offering loans because there is typically an interest rate attached to the loan.*
*0% auto financing is a notable exception, but that’s typically only offered via factory financing in order to sell more cars. Also, as you’ll see in our article about upfront costs versus monthly payments, a 0% payment rate doesn’t necessarily mean a consumer is being charged 0% interest overall. For instance, the auto buyer with the 0% loan may have had to choose that loan over, say, a $1500 cash back incentive. In that case, the buyer effectively paid $1500 in interest upfront in exchange for paying less over time.
Interest is additional money beyond amount borrowed that allows the lender to profit from the transaction. In the mortgage world especially, interest and interest rates are fairly complex topics. Other articles in this series will help you learn as much as you want to know about mortgage rates.
Key Concepts
Mortgage rates are interest rates on home loans
There are really TWO mortgage rates: the interest rate (or “note rate”) applied to your loan amount (or “principal”) and the rate implied by certain upfront costs (the “effective rate”).
APR (Annual Percentage Rate) attempts to convey that “effective rate.”
Understand the tradeoffs between upfront costs and payments over time
Principal (definition): the current balance of a loan/mortgage. In the absence of any additional costs or fees, the initial principal balance of a mortgage is whatever was borrowed to buy the home. Let’s say you buy a $200,000 home and are able to make a $10,000 down-payment (an upfront payment that reduces the amount of money borrowed). The principal in this case would be $190,000.
Principal also refers to the remaining balance after a mortgage payment. Each payment is typically contains some interest for the lender and can also contain property taxes, homeowners insurance and mortgage insurance. Whatever is left over goes toward reducing the principal balance (the amount you owe, which is slightly different from a “payoff balance”). In other words, as you make payments, the amount you owe decreases. When that amount reaches zero, you own the home outright!
Payoff vs Principal: If you’ve refinanced or sold a home before, you may have noticed that the amount required to pay off the old mortgage was slightly higher than the principal balance on the mortgage. This occurs because your monthly mortgage payment covers interest charged during the previous month. If you pay-off your loan in the middle of any given month, the lender hasn’t yet collected interest for that month. They’re not going to charge you for the entire month, however, only the number of days between the 1st of the month and the payoff date.
For example, your mortgage payment on June 1st would cover interest for the month of May. If you pay off your loan on June 10th, the lender has not yet been paid interest for those 10 days, and will add them to your payoff amount. This is true for both purchases and refinances. Many lenders charge a small additional fee to obtain the payoff balance for administrative costs associated with an early payoff.
Mortgage Rates are simply the interest rates applied to the principal balance, but there is an important distinction. What most people refer to as “mortgage rates” are actually only part of the equation. The more accurate term would be “note rates.” This refers to the interest rate on the promissory note (an official document that you’ll sign during the mortgage process).
Think of the promissory note and the note rate as a sort of baseline for the overall cost of financing. While it’s true that the note rate is 100% responsible for determining the monthly mortgage payment, it’s typically NOT the only cost of financing. Most mortgages have an “upfront cost” component.
Upfront costs are charged by multiple parties (examples include: lender, appraiser, credit bureau, local government taxes, homeowners insurance companies, attorneys/title company, etc.) Most of these costs will not change regardless of the loan type or the lender, but some will.
Upfront lender-related fees are common. They add to the overall cost of financing. Therefore, the NOTE rate differs slightly from the actual or “effective” rate you’re paying on your money.
The Truth In Lending Act stipulates that lenders must quote that effective rate in the form of APR or annual percentage rate. If you don’t read anything else on APR, it’s important to know that not all lenders calculate them the same way, and APR can’t necessarily be trusted as an apples to apples comparison between two or more lenders.
For the purposes of understanding mortgage rate building blocks, we’ll simply use the term “upfront costs.” Whether we’re talking about the interest portion of your mortgage payment or upfront lender-related costs, it’s all money that ends up going from your wallet to the lender. In most cases, you have some say in dividing up the lender’s upfront income versus their income over time.
For instance, you will typically have the option to pay more upfront in exchange for a lower interest rate. The industry has long referred to this type of extra upfront payment as “points” or “discount points.” Despite any negative connotation from certain financial media pundits, points are neither good nor bad--simply a choice to pay now or pay later.
Only you can decide which way makes most sense for your scenario. The only thing that really matters is the trade-off between the two choices.
If you invest your extra cash and earn a certain rate of return, you may be better off minimizing your upfront costs and putting that money into your investments.
If, on the other hand, you wouldn’t be earning a great return on that money and you know you’ll have the mortgage for a long time, it may make sense to “buy down” the rate with additional upfront cost.
Your lender should be able to show you the difference between those options in terms of the number of months it will take to break-even on the additional upfront cost. For example, you would pay $1200 in extra upfront costs and $14 less per month in scenario B. It would take 86 months to break even because $1200/$14 = 86.
SCENARIO A:
Upfront costs: $5000
Payment: $2000 per month
SCENARIO B:
Upfront costs: $6200
Payment: $1986 per month
86 months (or 7.16 years) is a fairly typical break-even time frame when you buy-down your rate. Break-evens vary from lender to lender and from rate to rate. In cases where the break-even time frame is 4-5 years or less, it’s an increasingly compelling option for people who plan to keep the new mortgage for a long time and who don’t have a great place to earn a high rate of return.
The bottom line is that it’s your choice and there’s no right or wrong way to do it.
In terms of understanding mortgage rates, the important concept is that of “upfront cost” vs “cost over time.” For any interest rate you hear about or see online, there are certain assumptions underlying that quote. It could be based on higher upfront costs than you had in mind or a higher credit score than you have (read more about how credit and other individual factors can affect rate. You won’t ever be able to know the actual rate until you know what those assumptions are.
NOTE: In lieu of choosing a mortgage with a higher rate and lower upfront costs, you may be able to increase the new mortgage balance in order to pay the costs--sometimes referred to as “rolling in.” This would keep the interest rate the same, but the payment would still be slightly higher because the loan balance is slightly higher. You’d also need to consider the fact that you’ll have more principal to pay off when it comes time to sell or refinance. Even then, this can sometimes be a more appealing option than raising the rate to cover the costs--especially if the upfront cost savings happens to be minimal between the quoted rate and the next rate higher (remember, they vary from rate to rate and lender to lender).
Mortgage Terms
Addendum
A document that is added to a real estate contract or purchase agreement.
Amortization
Repaying a debt over a set period of time.
Annual percentage rate (APR)
The interest rate along with other fees that you can expect to pay when securing a mortgage loan.
Appraisal
An approximation of a home's current value based on a range of factors such as the price of similar properties in the area.
Appreciation
The increase in a property's value over time.
Assessed Value
When a county, village, city, or town hires an assessor to determine the value of a property for tax purposes.
Broker
A real estate broker is qualified to represent a seller or buyer. He or she can choose to work independently of a firm, real estate agents must work with licensed brokers.
Closing
The final step of a real estate transaction when a property is finally transferred from the seller to the buyer.
Closing Costs
The costs and fees that come along with the purchase of a property.
Commission
This refers to 5 - 6% that a real estate agent makes at closing.
Construction loan
This is a short-term loan that covers the cost of building a property.
Conventional Mortgage
Ideal for borrowers with strong credit, this type of loan is not backed by a government agency like the Federal Housing Administration (FHA).
Deed
The deed refers to the legal document that transfers ownership of a property from a seller to a buyer.
Default
Default refers to when a homeowner fails to make several mortgage payments on time, according to the terms of the loan contract.
Delinquency
Means that a homeowner has failed to make a mortgage payment on time.
Down payment
The down payment is the amount of money a buyer has saved in order to purchase a property. This can typically range from 5 - 20% of the home's cost.
Equity
This is calculated by taking the difference between the amount owed to a lender and the market value of a property.
Escrow
During the home buying process, your money will be placed "in escrow" and is protected by a third party until the real estate transaction is closed.
Exclusive listing
An exclusive listing is when a seller commits to working with one specific broker and a designated agent on the sale of a property.
Fair Credit Reporting Act
This federal law determines how a consumer's credit information can be used.
Fair market value
The amount a property would sell for in a competitive market, or when a seller and buyer can agree on the price of a property.
FHA Mortgage
A Federal Housing Administration mortgage loan is backed by the government and is typically reserved for buyers with a low credit score or significant amount of debt.
Fixed-rate mortgage
This mortgage has the same interest rate for the term of the loan.
For sale by owner
This refers to a homeowner putting their property up for sale without assistance from a real estate agent or broker.
Foreclosure
A property goes into foreclosure when the homeowner misses mortgage payments and the lender tries to recover the balance of a loan.
Home equity line of credit
Also referred to as a HELOC, this is a second mortgage that allows a homeowner to borrow money against their home's value.
Home inspection
A home inspection involves the evaluation of a property's condition, including electrical work, sewage, and plumbing before the closing.
Homeowner's association
When a group of homeowners in a community, such as a condo, join in paying fees that cover the maintenance of the entire property.
Homeowner's insurance
Financial protection that helps with covering costs associated with repairs of a property or even replacement if necessary.
Lender
A lender is a financial institution or person that loans money to another party for the purpose of purchasing real estate.
Lien
A mortgage lender can place a lien on a property if the homeowner is not up-to-date on payments.
Mortgage
A mortgage is a loan that is used to purchase a home or other form of real estate.
Mortgage banker
A mortgage banker provides mortgage loans.
Mortgage broker
A mortgage broker acts as the middleman between mortgage borrowers and potential lenders.
Mortgage insurance
This form of insurance can protect a lender in the event that a homeowner defaults on their mortgage.
Negative amortization
When interest on a mortgage loan has not been paid to the lender, it's added to the loan balance.
Original principal balance
This is the balance of the mortgage loan before interest is taken into account.
Pre-approval
The pre-approval process involves a potential lender or bank reviewing an individual's finances, including their income, assets, and credit history, to determine how much money can likely be borrowed.
Prime interest rate
Banks offer customers who have proven to be creditworthy their best, or prime, interest rate.
Principal
The principal is the amount of money you borrowed from a lender, excluding the interest.
Real estate agent
A licensed professional who helps sellers or buyers complete real estate transactions.
Right of Refusal
A lease or contract might include "right of first refusal" to note that an individual has the right to put an offer on a property before it is listed on the market by a seller.
Second mortgage
Also known as a junior lien, a second mortgage is an additional loan taken on the same property. It typically has a higher interest rate than the primary mortgage and can be used for repairs, among other reasons.
Servicer
A servicer is a company that monitors and manages mortgage loans.
Title
This legal document states who has owned a property in the past and notes any liens associated with it.
Transfer of ownership
This means that a property has a new owner who purchased it and assumed its mortgage debt.
Transfer tax
A tax that is charged by a state, county, or city when ownership of a property is transferred.
Under contract
This refers to a prospective buyer and seller reaching an agreement on a property. At this early stage, both parties are in alignment with the terms of the deal, including the property's price and closing date.
Adjustable-Rate Mortgage
Adjustable-rate mortgages (ARM) offer variable interest rates. It usually begins with a lower interest rate than fixed-rate mortgages, but typically changes over time following market rates. If you don’t plan on staying in your home long-term, refinancing to an ARM can sometimes benefit you.
Amortization
Amortization refers to a payment schedule outlining what goes toward principal and interest balances. Typically, payment goes toward interest first and then the principal balance.
Annual Percentage Rate (APR)
APR is the annual cost of a loan expressed as an interest rate. It often includes loan origination fees, most closing costs, mortgage interest and any discount points.
Appraisal
Appraisals are an expert’s opinion of a home’s market value. Appraisers examine a home’s condition, location and similar properties recently sold. By law, appraisals are done by neutral third parties with no interest in the sale.
Appreciation
Appreciation is a home’s increased value over time. Historically, real estate appreciates from 3% – 5% each year nationally.1
As-Is
Sometimes a buyer will ask the seller to update the home during the offer process – like adding new carpeting or replacing an old roof. When a seller will not make any changes to a home, the home is being sold as-is.
Assessed Value
Assessed value is a professional estimate of a home’s market price for property tax purposes. Similar properties, the home’s location and its condition are considered when finding assessed value.
Backup Offer
If a buyer wants a home already under contract, they may request to be “next in line” by submitting a backup offer. Backup offers must still be negotiated with any fees – like earnest money – paid. There can legally only be one backup offer on a home at any given time.
Blind Offer
If you put an offer on a home without seeing it in person, you’re making a blind offer. This may happen when an out-of-state buyer is physically unavailable to see a new listing. It can also happen in highly competitive markets when viewing slots are immediately filled but a buyer still wants to compete.
Borrower
In real estate, you can pay for a home outright with cash or through a loan. When you pay using a loan, you are legally referred to as the borrower.
Bridge Loan
A bridge loan is a temporary loan used while permanent financing is being secured. Bridge loans often have higher interest rates. They are most often used when a seller needs funds for a new property before selling their own home.
Broker
When buying a home, you may work with a REALTOR® or a real estate broker. While these terms sound the same, they are not. A REALTOR® is a real estate professional who is member of the National Association Of REALTORS® and likely works under a broker or brokerage. Real estate brokers are agents who continue their education and receive a broker license. Real estate brokers can work independently and hire other agents to work under their supervision.
Buydown
A buydown happens when the borrower purchases a lower interest rate by paying a premium called a “point.” If you expect to increase your earnings in the future but want a lower payment now, a buydown may be a helpful option.
Buyer’s Agent/Listing Agent
What’s the difference between a buyer’s agent and a listing agent? A buyer’s agent represents the buyer’s interests – finding a home within budget that matches their preferences. The listing agent represents the seller’s interests – getting a good sale price with a deal likely to close.
Buyer’s Market/Seller’s Market
The real estate market will vary in who it favors: buyers or sellers. In a buyer’s market, conditions favor those looking to purchase real estate. This happens when the supply of homes for sale exceeds purchase demand. The reverse is called a seller’s market and favors those looking to sell real estate.
Cash-Out Refinance
Cash-out refinancing is a way to turn your equity into cash. Let’s say you own a home worth $250,000. You have $100,000 in equity and owe $150,000. You can refinance by setting up a new $200,000 loan with your lender and receive $50,000 cash at closing.
Chain Of Title
A chain of title is a document containing all previous property owners, listed in chronological order from the first owner to the present owner.
Clear Title
A clear title shows the undisputed, legal property owner. This means there are no liens or levies from creditors or other parties that may cause legal confusion.
Closing
Closing, or settlement, is the final step in the home buying process. This is where closing documents are signed, outstanding funds are paid and the title transfers from seller to buyer.
Co-Borrower
Someone who is financially responsible for paying back a loan, along with the borrower. If a husband and wife take out a home loan together, one may be the primary borrower and the other a co-borrower.
Commission
Commission is payment based on the completion of a sale. REALTORS® or agents work on commission, which means they will receive a portion of the home sale as payment upon closing.
Comparables
Comparables are recently sold properties that help appraisers determine a home’s fair market value. They are similar to the listed property in size, location and available amenities.
Compound Interest
Compound interest accumulates from both your principal balance and interest owed. On a loan, this means you will progressively owe more interest. On an investment, you will progressively make more money from compounding interest.
Contingency
A contingency is a condition that must be met before the sale is legally binding. For example, a buyer can make their offer contingent on a satisfactory home inspection. If this contingency is not met, the sale may fall through.
Conventional Mortgage
Conventional mortgages are funded by private lenders rather than government-backed agencies. Most often, these loans are then sold to government-sponsored enterprises like Fannie Mae or Freddie Mac to provide liquidity to the nation’s mortgage market.
Debt-To-Income Ratio
Your debt-to-income ratio is your monthly debts (home, car, credit card, student debt payments, etc.) divided by your monthly gross income. Lenders use this percentage to help determine your ability to repay a potential loan.
Deed
A deed is a legal document showing property ownership. As the buyer, your deed is signed and delivered to you at closing.
Deed In Lieu Of Foreclosure
If a borrower needs relief from mortgage debt, they may choose to do a deed in lieu of foreclosure. This transfers deed ownership to the lender in exchange for debt forgiveness to avoid foreclosure.
Default
Default is when a borrower fails to make several loan payments over a period of time. Lenders and government agencies use set timeframes to decide at what point a loan moves from delinquency to default. For example, a loan is not in default until 270 days of missed payments, according to the Code of Federal Regulations.
Delinquency
Delinquency is even a single missed mortgage payment. If failed payments continue, the loan is at risk of entering default status.
Down Payment
Your down payment is a percentage of the home’s sale price paid upon closing to secure your loan. You can typically avoid private mortgage insurance with a down payment of 20%. However, many lenders allow loans with smaller down payments.
Due Diligence
Due diligence is the period of time when a buyer examines a home’s condition and contract terms before becoming legally obligated to purchase. Due diligence is your time to discover and consider any financial risk associated with investing in a home.
Earnest Money
Earnest money is part of your down payment paid before closing to show you are serious about purchasing a home. It is also known as a good faith deposit.
Eminent Domain
The government retains the right to take private property and convert it for public use if it compensates the owner fairly. This right is known as eminent domain.
Equal Credit Opportunity Act (ECOA)
This act prevents creditors from discriminating against applicants because of their: Age, Race, Religion, Sex, Marital status, Receipt of public assistance, Exercising rights under the Consumer Credit Protection Act.
Equity
Equity is how much of a home’s value can be attributed to the owner. It’s calculated by subtracting the amount owed from the home’s market value. So, if your home is worth $250,000 today, but you still owe $150,000, your equity in the home is $100,000.
Escrow
Escrow is a legal arrangement where a third party holds large funds until terms of an agreement are met. In real estate, you’ll set up an escrow account to hold funds for taxes or insurance throughout the life of your mortgage.
Exclusive Listing
An exclusive listing occurs when a seller contractually agrees to work with only one broker. In contrast, an open listing means the seller may allow multiple brokers to list the home for sale and offer representation.
Fair Credit Reporting Act
FCRA protects consumers’ privacy and dictates how credit bureaus are allowed to collect and distribute information. Your lender is allowed to request your credit report during your mortgage application under the FCRA.
Fannie Mae
The Federal National Mortgage Association, commonly known as Fannie Mae, is a government-sponsored corporation that helps provide affordable housing. Fannie Mae purchases loans from origininating lenders and sells them to private investors. This helps free lenders from financial burden so they can continue to offer loans to new borrowers.
FHA Loan
The Federal Housing Administration (FHA) insures these loans to help provide more affordable housing, especially to first-time home buyers. FHA loans often offer lower down payments, closing costs and credit requirements.
FICO Score
A FICO score is the most common credit score report used by lenders. Developed by the Fair Isaac Corporation (FICO®), this report generates a number based on: Your payment history, Owed debts, Credit history length, Types of credit currently in use, How much new credit you have.
When considering a FICO® Score, lenders associate a higher number with a person less likely to default on their loan.
Fixed-Rate Mortgage
This mortgage guarantees one interest rate for the duration of your loan. With a fixed-rate mortgage, your monthly principal and interest payment never changes.
Foreclosure
When a borrower fails to make agreed-upon payments to the lender, the lender can take possession of the home in a legal process called foreclosure. The lender may then sell the property on the market to pay off the defaulted loan.
Freddie Mac
Federal Home Loan Mortgage Corporation, commonly known as Freddie Mac, is a government-sponsored corporation that helps provide affordable housing. Freddie Mac purchases loans from original lenders and sells them to private investors. This helps free lenders from financial burden so they can continue to offer loans to new borrowers.
Grace Period
If you submit your monthly mortgage payment late, you may incur late fees. However, many loans offer a grace period where late payments do not incur fees. For example, your loan may specify a 2-week grace period, so you could submit your payment up to 2 weeks late without incurring fees.
Home Equity Line of Credit (HELOC)
A home equity line of credit is a loan where you can borrow money against your home’s equity when you want it, not as a lump sum. This loan has an agreed-upon maximum borrowing amount in an agreed-upon time period.
Homeowners Insurance
Homeowners insurance protects your home from damages covered in your policy. Not sure what your policy covers? You can find out by checking your declaration page. Homeowners insurance is required by mortgage lenders, and you must purchase a policy before closing on your home.
Inspection
A home inspection examines a home’s condition to find any major safety or structural issues. Inspections usually look at a home’s exterior, electrical system, roof, plumbing, water and HVAC systems.
Jumbo Loan
Every year in January, government-sponsored corporations Fannie Mae and Freddie Mac set conventional loan limits. Loans that exceed these limits are nonconforming jumbo loans.
Lender
A lender is a financial institution that offers home loans or other credit lines.
Lien
A lien secures payment by giving the lien holder a legal claim to the property. A mortgage is a type of lien because your lender can legally repossess your property if you fail to make payments.
Mortgage
A loan to purchase or refinance a home is called a mortgage. Mortgage can also refer to the legal document pledging the property as collateral on the loan.
Offer/Counteroffer
An offer is a buyer’s legal proposal to purchase a home under a certain set of conditions. A counteroffer is a seller’s response – typically agreeing to the offer with one or two changes.
Pending
When a seller accepts a buyer’s offer, the home becomes pending. Sellers usually cannot consider new offers once the sale is pending, but you may be able to submit a backup offer.
PITI (Principal, Interest, Tax, Insurance)
PITI is an acronym used to show the four elements of your monthly mortgage payment: principal, interest, tax and insurance.
Private Mortgage Insurance (PMI)
Private mortgage insurance is a policy that protects your lender in case you default on your loan. Usually, if your down payment is less than 20% on a conventional loan, you will also need to pay for PMI.
Preapproval
Preapproval is the process of establishing what a borrower can reasonably afford when taking out a loan. Lenders will look at your income, debts, assets, credit and other information during the preapproval process.
Principal
Principal is the amount owed to the lender outside of interest.
Purchase Agreement
A purchase agreement is a contract between a buyer and seller stating the terms of the home sale. It may stipulate conditions like sale price, what appliances will stay in the home and when the buyer will move in.
Real Estate Agent
A real estate agent is someone licensed to represent a buyer or seller in a real estate transaction. Most real estate agents work under a licensed broker or REALTOR®.
REALTOR®
A REALTOR® is a real estate agent who is also a National Association of REALTORS® member.
Refinance
Refinancing is obtaining a new loan to pay off an original loan on the same home. Often this is done to get better loan conditions, like a lower interest rate.
Second Mortgage
A second mortgage is another loan taken out using your home as collateral. A HELOC is a common type of second mortgage.
Seller’s Disclosure
A Seller’s Disclosure is a legal document sellers must fill out stating any home defects that may affect its value. Requirements on what must be disclosed vary by state.
Title
A title shows ownership of a property. It differs from a deed in that a deed is a physical document and a title is not. Title represents the concept of ownership, and can apply to a home, car, boat, etc.
Under Contract
When a buyer and seller agree on a purchase agreement, the home moves to “under contract” status. This means both parties are legally obligated to proceed with the sale so long as conditions are met.
Underwriting
Underwriting is the process used to determine loan conditions and protect lenders from financial risk. Underwriters may look at a borrower’s credit, employment history and debt, as well as the property’s condition, to determine loan eligibility.
VA Loan
A VA loan is guaranteed by the U.S. Department of Veterans Affairs. It is a top benefit of military service for veterans, active-duty military, reservists and qualified surviving spouses. Under a VA loan, you usually don’t need a down payment and will avoid paying PMI.