Mortgage Definitions (Key Terms You Should Know)

So, you have decided you are ready to buy a home. Congratulations! Starting on the journey from homebuyer to homeowner is a thrilling endeavor, but before you jump into house hunting, it is important to conduct some initial research.

As you begin your homebuying journey, it can be helpful to become familiar with the key mortgage terms you are likely to encounter during the homebuying process. That is why we have compiled the ultimate list of mortgage terms and their definitions.

Read on for more information and added homebuying confidence.

Mortgage Basics

Mortgage

A mortgage is a type of loan that is used to purchase a home and the property itself is used as collateral.

Principal

The total amount of money your lender provides for your home purchase, excluding interest.

Interest rate

Where your interest is the amount paid in order to borrow money from a lender, your interest rate is an annual percentage of your balance that determines how much you will pay to borrow that money. More often than not, this will be the percentage advertised by mortgage lenders to potential borrowers.

Annual percentage rate (APR)

The annual percentage rate, or APR, is a percentage that represents the yearly cost of your mortgage. It is typically higher than your interest rate as it includes all of the costs associated with a mortgage. These costs include interest, origination fees, mortgage insurance, and more.

Loan term

Your loan term refers to the length of time that you agree to repay your mortgage loan. The most common lengths for a loan term are 15 or 30 years.

Fixed-rate mortgage

A fixed-rate mortgage has an interest rate that does not change or fluctuate for the life of the loan. Fixed rates are typically preferred over adjustable-rate mortgages (ARMs), because they provide predictable monthly payments and make budgeting much easier.

Adjustable-rate mortgage (ARM)

An ARM is type of mortgage that has an interest rate subject to periodic changes based on housing market conditions and current rates. With an ARM, you will have two distinct periods: an initial fixed-rate period during which the rate does not change, typically ranging from three to ten years; and an adjustable-rate period after which your rate may change every six months or year.

Principal, interest, taxes, and insurance (PITI)

The four elements of your mortgage payment are principal (how much you borrowed), interest (the finance rate at which you purchased your mortgage), taxes (how much you owe the government), and insurance (the costs to protect your investment). Sometimes you will hear about P&I—that just means principal and interest. It is important to keep all four of these factors in mind when planning your budget.

Loan Types

Conventional loan

A conventional loan is your standard-issue, classic home loan option. This type of loan is secured and offered by a private financial institution—not a government agency. Typically, when you hear people mention a mortgage, they mean a conventional mortgage.

Federal Housing Administration (FHA) loan

An FHA mortgage is a type of loan backed by a government agency known as the Federal Housing Administration. This type of loan is intended to make homeownership more accessible to a wider group of people, with lower down payments and more flexible financial requirements.

Veterans Affairs (VA) loan

A VA loan is a type of government-backed mortgage specifically for military members and their families. The U.S. Department of Veterans Affairs (VA) issues these loans to qualifying service members as a special thank you for everything they do.

They feature low rates and no down payments. But there are specific requirements for VA loans, like VA funding fees, and not all lenders are fully equipped to deal with these logistics.

Jumbo mortgage

Conventional mortgages are only offered up to a certain amount. For higher amounts, outside the limits of government-conforming loans, you may need to apply for a jumbo mortgage. These types of loans can be used to buy more expensive homes, but may carry certain risks since they are not approved by Fannie Mae or Freddie Mac.

Interest rate reduction refinance loan (IRRRL)

An IRRRL is a type of VA loan program that allows service members to refinance their mortgage to a lower rate (and by extension, lower monthly payments). Compared with conventional refinance options, IRRRLs typically have more strict requirements and faster processing times.

Financial Terms

Down payment

The down payment for a mortgage is an initial, up-front payment made by a homebuyer at closing. It is typically represented as a percentage of the total purchase price, and the minimum down payment you must provide will vary depending on the type of mortgage you are using.

Historically a 20% down payment was considered standard, but with different programs and loan types, it is possible to put much less money down. However, it is good to remember that the more money you can put down up front, the smaller your monthly mortgage payments will be.

Loan-to-value ratio (LTV)

An LTV ratio is the formula your lender will use to assess the risk of lending money and measures the total amount of a home loan against the value of the property being bought. This is why your down payment is factored into the equation. For example, if you are able to provide a 20% down payment, then your LTV ratio is 80% right from the start.

Debt-to-income ratio (DTI)

DTI refers to the percentage of your monthly income spent on paying off debt. Your lender will calculate your DTI ratio using the minimum monthly payments on all applicable debt and dividing that total by your gross monthly income. While DTI requirements vary depending on the type of mortgage and your lender, a ratio of 43% or less is typically accepted by most lenders.

Amortization

In the mortgage world, amortization refers to the gradual reduction in the amount of principal you owe over time based on your interest rate. When your mortgage is approved, you agree to a monthly payment that factors in your amortization rate. When it is all paid off, you can say the loan is fully amortized.

Break-even point

When it comes to mortgages (specifically mortgage refinancing), the break-even point is the time at which your savings start to exceed the initial costs of a refinance.

Cash to close

When you hear the term “cash to close,” it is referencing the total amount of money that you need to provide in order to close on a home purchase agreement. This total includes your down payment, closing costs and fees, plus any prepaid expenses.

Equity

In home finance, equity is the amount of accessible value that is in a property. You can tap into that equity with a cash-out refinance, home equity line of credit, or by selling. The equity in a home should climb over years, making real estate a relatively dependable investment.

Mortgage points

Also known as discount or buydown points, mortgage points can be used by homebuyers to offset the cost of a mortgage. These points are technically prepaid interest that you pay upfront at closing in exchange for a lower interest rate and decreases your monthly mortgage payment amount.

Application Process

Pre-qualification

Getting pre-qualified for a mortgage can be a great first step to establishing a relationship with potential lenders. When you prequalify for a home loan, you are getting an estimate of what you might be able to borrow, based on information you provide about your finances. Your pre-qualification letter indicates that a lender is likely to lend you money up to a certain amount based on the financial information you provide them. However, in order to start submitting offers on homes, you will need to undergo a more thorough financial review and receive pre-approval from a lender.

Pre-approval

Though it is not a guaranteed loan offer, a mortgage pre-approval is provided by lenders to indicate how much funding they are willing to provide to help you purchase a home. Your pre-approval will be contingent upon a review of your financial information. However, it is important to note that pre-approval can be rescinded at any point prior to the loan closing.

Commitment letter

A mortgage commitment letter is proof that a lender is willing to provide you a mortgage. This important document is obtained through the pre-approval process and helps demonstrate to sellers that you are 100% serious and ready to buy. You can get one by proving that your income is enough to afford a certain mortgage payment.

Loan estimate

A loan estimate is an official three-page document furnished by your lender to outline the details of a mortgage. It includes valuable information like the loan term, amount, estimated monthly payments, loan origination fee, and other costs required for closing. It is important to note that these numbers are subject to change up until the deal is locked in.

Appraisal

A real estate appraisal is the evaluation and resulting official opinion about the value of a property. An appraiser is an individual with the training and experience required to professionally formulate such an opinion.

Appraisers will assess the condition of your home, its location, the market, and other factors to determine an accurate price for the property. This is known as the appraised value.

Home inspection

Before buying a home, you will want to get it officially inspected. A home inspection should be carried out by a professional who can flag any potential issues with the house in question, including plumbing, wiring, structural integrity, and so on.

Rate lock

A rate lock, also called a mortgage rate lock or rate protection, is an agreement or offer between a lender and borrower that guarantees your current rate will not change for a set amount of time. The “lock period” begins during a home loan’s initial approval and extends through to the loan closing, typically a range of 30 to 60 days.

Locking in your rate especially comes in handy in tumultuous markets, eliminating one more variable from the homebuying equation.

Underwriting

Loan underwriting is the process conducted by your lender to determine the risks associated with lending you the money to purchase a home. It typically involves verifying your financial information and using it all to approve or deny your mortgage application.

Closing and Legal Terms

Purchase agreement

A purchase agreement is a legal document that states a buyer’s formal interest in buying a home. This contract will outline the conditions and terms of the sale, including the offer amount, expiration date, buyer and seller information, and the closing date.

Closing (settlement)

The last step in any real estate transaction, closing is the official transference of a deed from seller to buyer. It is also known as settlement. Paperwork is signed, closing costs (also called settlement fees) are paid, hands are shaken, and keys are obtained. Typically, the whole process lasts between one and a half and two hours if everything goes smoothly.

Closing disclosure

This essential document is the key to the whole closing process. Your lender will provide your closing disclosure three business days before closing day. It includes all of the relevant details about your loan terms, projected payments, and closing costs. Buyers will want to go over all of this information and flag any errors before arriving to close on a property.

Closing costs

Your home loan’s closing costs and fees are the added expenses that a buyer must pay on closing day to complete the home transaction. These costs typically range from 2% to 6% of your total loan amount and include origination and underwriting fees, appraisal cost, mortgage insurance premiums, and taxes.

Deed

The deed to a property is the official document that indicates its ownership. When you buy a home, the deed is transferred to your name. It is also notarized and filed as a public record so everyone is on the same page.

Earnest money

Also known as a good faith deposit, earnest money is an up-front payment that accompanies an offer to purchase. It assures a seller that you are seriously interested in a property. Typically, between 1% and 5% of a home’s asking price, this money can go toward a down payment or closing costs. It can be kept by the seller if the deal falls through or refunded to the buyer if certain conditions are met.

Escrow

Escrow is a legal agreement designed to keep funds safe and sound during a real estate transaction. A third party holds onto the earnest money deposit until a deal goes through, directing the funds securely and as agreed to by both the buyer and seller—often to cover insurance, taxes, and other costs. When money is in an escrow account, neither party may access or amend the amount.

Insurance and Protection

Title insurance

This type of indemnity insurance exists to protect lenders and homebuyers from potential issues with the title of a property. For instance, if a title company discovers a previously unknown lien or claim to a property, title insurance can help pay to resolve the resulting legal conflict.

Mortgage insurance

Mortgage insurance is intended to make homeownership more affordable for those who have less than a 20% down payment. Unlike other types of insurance that protect assets, mortgage insurance protects lenders in the event of a borrower default.

Private mortgage insurance (PMI)

PMI is used with conventional loan borrowers that have a down payment less than 20%. It is typically paid as a monthly fee that is included in your monthly mortgage payments.

Mortgage insurance premium (MIP)

MIP is a requirement on all Federal Housing Administration (FHA) loans, even if your down payment equals or exceeds 20%. It includes an up-front mortgage insurance premium (UFMIP) as well as an annual premium that is paid monthly.

Flood insurance

In some neighborhoods, you may need to factor in funds for flood insurance to protect from damage caused by rising waters. Typical for homes in coastal and low-lying regions, flood insurance is an extra cost to be aware of during the budgeting process.

Special Situations

Foreclosure

The legal process in which a borrower has failed to make their mortgage payments, and the lender takes possession of the home and property. When a homeowner cannot make payments on a mortgage, lenders may be forced to foreclose on their property. Foreclosure is the process of transferring ownership to a lender so they may sell it to recoup the losses incurred by an unpaid mortgage.

Refinance

In general terms, refinancing is the act of switching from one mortgage arrangement to another. Most often, this is done to reduce the interest rate or term length of your loan—often referred to as a rate and term refi. There are other reasons to refinance as well, such as eliminating your mortgage insurance, cashing out equity in your home, or accessing greater benefits with a different lender.

Cash-out refinance

This type of loan refinance allows you to directly access the equity in your home, turning it into usable capital—hence the term “cash out.” You can use that cash however you like, but often it is wise to put it toward a home improvement, repair, or renovation: something that will increase the value of your home in the long run.

Bridge loan

Designed for short-term use, a bridge loan is a financing option designed to help borrowers during a transitional period. This can be beneficial when you are buying and selling at the same time. They are typically more expensive than other sources of financing, so should only be used when absolutely needed.

Buydown

Sometimes known as buying mortgage points, a mortgage buydown is a strategy to temporarily lower the interest rate, and therefore your mortgage payment, on your home loan. A one-time up-front fee is required, but it could end up saving you money over time.

To determine if this option is right for you, you will want to calculate your break-even point based on factors like current interest rates and how long you intend to wait before moving again.

From curious homebuyer to confident homeowner

In the world of realty, there are all kinds of complicated terms that seem custom-crafted to confuse buyers and sellers. But you do not have to worry! This list will be here to help when you feel ready to dive into the homebuying process and all of the mortgage terminology that comes with it.

Do not forget to explore the Mortgage Knowledge Center to learn even more. Because an informed homeowner is an empowered homeowner.