Home buying can be a confusing experience, especially when the documents you have to sign include lots of unfamiliar terms. Here are some of most common terms encountered during the process. If you still have questions, please contact us for a more detailed explanation of any of the terms and any part of the process.
1. Adjustable Rate Mortgage (ARM): Traditionally a mortgage is for a fixed interest rate for the entire duration of the mortgage, usually 15 or 30 years. With an ARM, the most common of which are 7/1 or 5/1, the borrower has a lower initial interest rate for the first 7 years of the mortgage period, usually 30 years.
After 7 years, the mortgage rate resets yearly (what the 1 in 7/1 refers to) to reflect the current mortgage rates. The risk is that you cannot predict what this rate will be, and it may end up being much higher than you can afford.
For example, a 30 year mortgage might have a fixed rate of 5%, so your payments will be the same every month for the next 30 years. With a 7/1 ARM, you might have an initial rate of 4% for your monthly payments in the first seven years. On a $400,000 mortgage that 1% difference in interest rates is a savings of $240/month. But after 7 years, the mortgage will then adjust every year: it might be 4% some years, it might be 8%, or higher other years. (If you want to check out the math yourself, there is a free mortgage rate calculator on the Bankrate site.)
So why take the risk of an ARM? If you think it likely you will sell your home and move in the next 5-7 years, then you get the advantage of the lower monthly payments. Once you sell your house, you most likely will have a new mortgage with a new rate regardless of what type of mortgage you originally had. If you plan to be in your home for a long time though, the ARM may end up costing you much more over the full life of the loan. The borrower needs to watch how interest rates are trending and may need to refinance to a fixed rate mortgage depending on how the market is behaving.
2. Appraisal: If you are getting a mortgage, the bank (lender) will send out an appraiser to assess the value of the property before the sale is complete. This is an important step because it is either the appraised value of the home, or the purchase price, whichever is lower that is used to determine the loan-to-value ratio. The loan-to-value ratio (LTV) is a fancy way of saying what percent of the home’s value is being borrowed when purchasing. When the LTV is higher than 80% usually you will have to take out mortgage insurance or the bank may decide not to give you a mortgage. If you borrow $400,000 to purchase a $500,000 house, the LTV is 80%: $400,000 divided by $500,000. If you borrow $380,000 to purchase that same $500,000 house, the LTV is 76%: $380,000 divided by $500,000.
As an example, you are purchasing a home from a seller and agreed on the price of $500,000. Typically you will put down 20% ($100,000) and borrow the remaining 80% (ask for a mortgage for $400,000). If the bank appraises the home for $480,000.00, however, they will only approve a mortgage for $384,000 (80% of the appraised value of $480,000). Your $100,000 plus the bank’s $384,000 leaves you with only $484,000 for the purchase. In these circumstances, you may need to put down an additional $16,000 to cover the difference, you may try to negotiate a price reduction with the seller, the bank may require mortgage insurance or the sale has to be terminated.
Why does the bank need to make an appraisal, why not use the purchase price?
The bank needs to determine that their loan (your mortgage) is a good investment, and to do so, they need to determine what the property you are purchasing is worth other than the price you are willing to purchase. After all, if you pay $1 million for a home, then default on your mortgage, the lender will take that home. If it turns out you wildly overspent and the home was only worth $100,000, the bank is now stuck with a much larger loss than expected. The appraisal is the banks way of managing these risks.
Why doesn’t the bank only use the appraised value, why do they use whichever is the lower between appraised value and purchase price?
Imagine if you purchase a house for $450,000 but it is appraised at $600,000. If the bank uses the appraised value of $600,000 to determine the LTV, then you could put $0 and still have an LTV of 75% ($450,000 borrowed divided by $600,000). Most banks would find that scenario where the buyer does not put money down as too risky. Since the banks tend to have the upper hand, they can determine the circumstances by which they are comfortable lending money.
3. Attorney review: In New Jersey, buyers and sellers may execute a contract prepared by the Realtors. Both parties are then given three business days to confer with an attorney to discuss all issues, propose any changes, or even terminate the contract. Once attorney review is successfully completed, the contract is binding on both parties and cannot be changed or broken other than by mutual consent.
4. Escrow: This term usually refers to sums of money that are being held by a third party, typically by a bank or attorney, until a certain event is completed, such as closing title to the house. The money is not being used by the bank or the attorney. Rather, the purpose of escrow is to make sure that the funds available now will still be available in the future. When you take a mortgage, the bank may require money to be held aside for homeowner’s insurance and property taxes. Each mortgage payment will include this money that goes to escrow, so that when the insurance or real estate taxes are due, the money is automatically taken from the escrow account.
5. PMI: The PMI or Private Mortgage Insurance is almost always required by the lender if you are borrowing more than 20% of the appraised value or sale price. This insurance protects the lender (bank) if the borrower defaults on the loan and can no longer make payments. This may seem frustrating because it is an additional cost to the borrower, for the benefit of the bank. But by removing some of the risk of default, the bank becomes more likely to approve the loan. The PMI is a monthly payment that is included in the total amount of your monthly mortgage payment. The fee varies, but may be in the .5-1% (of the value of the loan) range. Once the loan-to-value ratio drops below 80%, you can notify the lender* to discontinue the PMI. At closing, you will be able to see how long it will take to reach the 80% level.
*Lenders must automatically cancel PMI when the outstanding loan balance drops below 78%.