Part I: Introduction to Mortgages and Decoding the Jargon
At Divvy, we believe that homeownership isn’t something you have to achieve in one mammoth step. Instead, we consider it a goal to build towards brick by brick, and we’re committed to helping you gain the necessary knowledge to get there. To reach the goal of owning your home, a mortgage will be one of your most essential tools. That’s why we’ve put together this comprehensive guide to help you understand the core principles of mortgage financing. Breaking down the mortgage product and its technical jargon into digestible and clear components can help make the material a little more accessible, arming you with the necessary information to navigate the process of buying your home. The mortgage process can seem intimidating, but with Divvy, it doesn’t have to be!
In Part I, we will discuss the basic definition of a mortgage and explain some key terms and concepts you are likely to encounter. In Part II, we will dig deeper into how a mortgage actually works, walk you through the mortgage process and explore the differences between a mortgage and Divvy.
Ready to learn how a mortgage can get you closer to your dream of becoming a homeowner? Let’s jump in.
What Exactly is a Mortgage?
First off, a “mortgage” is nothing more than a fancy word for a loan that is secured by “real property” (a house or land). For most people, a mortgage is simply a loan used specifically for the purchase of a home. A mortgage is “secured”, meaning that the home acts as collateral for the loan, and the size of the loan will be driven by the value of that collateral. If the homeowner fails to make payments on the mortgage, the lender can take possession of the home (i.e., “foreclose”) in order to pay off the loan. Mortgages come in many varieties, each with its own nuances, restrictions, and regulations, but they all are in effect tools used to purchase a home over time.
As you begin to deepen your understanding of the mortgage process, there are a few key terms and concepts that you are likely to come across, so we thought it helpful to define them:
I. Loan-to-value (LTV): “Loan-to-value” (or “LTV”) is a ratio that represents the relationship between the mortgage (the “loan”, in this case) to the value of the property. For example, a $90,000 mortgage on a home valued at $100,000 would have an LTV of 90% ($90,000 divided by $100,000).
II. Interest rate: The interest rate is the cost of borrowing, defined as a percentage of the total amount of the loan. It is important to note that the interest rate is typically expressed annually, sometimes with the letters “p.a.” (which stands for “per annum”, Latin for “each year”). For example, a 6% interest rate on a $90,000 loan would mean that you pay $5,400 ($90,000 x 6%) in interest over the course of a year, or $450 per month ($5,400 divided by 12). Because of the way that most mortgage payments work, your monthly payment will be more than that, and the amount of interest will actually vary (more on this later!).
It is important to distinguish the interest rate from the “Annualized Percentage Rate” (or “APR”), which is a calculation that includes not only the interest rate but also any “points” (see below) and certain other costs, such as mortgage brokerage fees, charged upfront. The interest rate is what dictates your monthly payment, whereas the APR is meant to reflect the full cost of borrowing over the life of the loan, expressed as an annual percentage.
III. Floating rate v. fixed rate: These are variations on interest rates that you may come across. A “fixed rate” loan means that you pay the same interest rate throughout the life of the loan (e.g., 6%), whereas a “floating rate” (sometimes called a “variable rate”) loan will reset periodically based on a benchmark rate (such as “LIBOR” or “Prime” – see below). For example, a floating rate loan priced at LIBOR plus 3.25% would be 5.85% today (with LIBOR at 2.60%), but would have been 5.61% a year ago (when LIBOR was at 2.36%).
“LIBOR” and “Prime Rate” are interest rate indexes based on the rates major global banks charge when borrowing from one another (LIBOR stands for “London Interbank Overnight Rate”). LIBOR and Prime are commonly used as benchmark rates in many lending transactions. These rates are published daily in most financial newspapers and can also be found on websites such as Bankrate.com and Bloomberg.com.
An “adjustable-rate mortgage” (or “ARM”) is a common product that combines fixed and floating rates: an ARM has an initial fixed rate period (which can range from as little as a year up to as many as 10 years), after which the loan converts to a floating rate instrument. Usually an ARM is referred to by the number of years for which the interest rate is fixed, and then how often it “resets” following that initial period – so for example, a “5/1 ARM” means the interest rate is fixed for 5 years (that’s the “5” in 5/1), and then switches to floating, with a reset every year (that’s the “1”).
IV. “Points”: Points are a one time fee that you pay at the time of closing as a way to reduce your mortgage interest rate. For example, a bank might offer a mortgage at 6% with no points, or a mortgage at 5.875% with 2.00 points (or 2.00%) paid upfront. If you elected to pay the points, you’d pay some money upfront but your monthly payment would be slightly lower for the duration of the loan. If you elect not to pay points, your monthly payment is slightly higher, but you avoid having to pay out of pocket at closing.
This gives us an opportunity to think more about the distinction between interest rate and APR: in the example above, the APR of the first offer (6% / 0 points) is 6%, whereas the APR of the second offer (5.875% / 2.00 pts) is actually 6.02% — so while you’re paying less interest (5.875% v. 6.00%), your total cost of borrowing is actually higher. That’s why it is important to understand both!
V. “Conforming” v. “Non-conforming”: A “conforming mortgage” is one that meets the standards of government regulated entities such as the Federal National Mortgage Association or the Federal Home Loan Mortgage Corporation (more commonly referred to as “Fannie Mae” and “Freddie Mac”, respectively, or simply “Fannie” and “Freddie”). Because mortgages that meet these agencies’ standards are eligible to be purchased or guaranteed by the government, “conforming mortgages” are generally cheaper. You may also hear conforming mortgages referred to as “Agency Mortgages”, meaning they meet the standards of the federal mortgage agencies. “Non-conforming mortgages” are those that do not meet those standards are not eligible to be purchased or guaranteed by the government, and as a result are usually more expensive.
Mortgages are also available to certain borrowers through separate programs administered by the Federal Housing Authority (the “FHA”) or the Veterans Administration (the “VA”) — be sure to explore whether you can qualify for one of these mortgages, because the terms can be even more attractive than conventional “agency mortgages”.
“Jumbo-Loans” are one type of non-conforming mortgages; jumbo mortgages are those in excess of the maximum limit set by Fannie and Freddie, currently set at $484,350 (the limits are reviewed each year). A mortgage in excess of that amount is non-conforming and therefore tend to be more expensive and are more difficult to qualify for.
VI. “Principal and Interest” v. “Interest Only”: – A “principal and interest” (or “P&I”) loan is the most common form of mortgage. Under a P&I mortgage, your monthly payment will include a portion that goes to reduce the principal as well as paying the interest. (The “principal” is the amount you actually borrowed.) With an “interest-only” (or “IO”) mortgage, on the other hand, the borrower is only required to make payments on the interest, not the principal, typically for a set amount of time. For example, you may see a 30-year mortgage advertised as having a 5-year “IO” option, meaning you are only required to make interest payments during the first 5 years if you choose. An IO mortgage can be less expensive in the short term, but may require that you to pay more down the road, and also means you build equity more slowly. (We’ll talk more about the actual mechanics of the monthly mortgage payment, and how your ownership stake increases over time, in next week’s blog.)
VII. “Private Mortgage Insurance”: Private Mortgage Insurance, or PMI, is a type of insurance that you may be required to purchase if you take out a conventional loan, protecting the lender in the case the purchaser stopped making payments on the loan. Usually PMI is required if the LTV of the mortgage exceeds 80%, and costs somewhere between 0.50-1.00% per year.
This glossary of terms will help anchor you as you become more familiar with mortgage financing and the mortgage process. By decoding the industry jargon we hope you will see that the mortgage process is far more straightforward than it may have appeared at first glance.
Check back next week for part II of this post, where we will dig deeper into the details of mortgage financing and the mortgage process while comparing the structure and cost of a typical mortgage with those of Divvy. And if you have any questions or just want to chat about the process, don’t hesitate to reach out to the team at Divvy — we are all committed to helping you achieve your dream of home ownership, and are always happy to hear from you!