Mortgage Basics

Click on a term to learn more about it.


A mortgage where the interest rate is not fixed, but changes during the life of the loan in line with movements in an index rate. You may also see ARMs referred to as AMLs (adjustable mortgage loans) or VRMs (variable-rate mortgages).


Known by various names, such as contract of purchase, purchase agreement, or sales agreement according to location or jurisdiction. A contract in which a seller agrees to sell and a buyer agrees to buy, under certain specific terms and conditions spelled out in writing and signed by both parties.


A payment plan which enables the borrower to reduce his debt gradually through monthly payments of principal.


A measure of the cost of credit, expressed as a yearly rate. It includes interest as well as other charges. Because all lenders follow the same rules to ensure the accuracy of the annual percentage rate, it provides consumers with a good basis for comparing the cost of loans, including mortgage plans.


A short-term fixed-rate loan which involves smaller payments for a certain period of time and one large payment for the entire amount of the outstanding principal. Usually they have terms of 3, 5, and 7 years.


A mortgage which requires a payment for half the monthly amount every two weeks. As a result the loan amortizes much faster than a loan with normal monthly payments. For example, a 30 year fixed rate loan will be paid off in approximately 19 years.


A limit on how much the interest rate or the monthly payment can change, either at each adjustment or during the life of the mortgage. Most ARMs have an interest rate caps to protect you from enormous increases in monthly payments.

A lifetime cap limits the interest rate increase over the life of the loan. Lifetime caps can vary by lender, but most ARMs have caps of 5% or 6%. A periodic or adjustment cap limits how much your interest rate can rise at one time. Generally, a 6 month ARM will have a cap of 1% while a 1 year ARM will have a 2% cap.

Periodic and lifetime caps are quoted as two numbers as in 2/6 which would mean that periodic cap is 2% and the lifetime cap is 6%. Examples:
  1. The initial interest rate is 4.5%, the index is 7%, and the margin is 3%,
    then the new interest rate = 7% + 3% = 10%.
    If the lifetime cap is 5% then
    the actual new interest rate will be 4.5% + 5% = 9.5%.
  2. The initial interest rate is 6%, the index is 5%, and the margin is 3%,
    then the new interest rate = 5% + 3% = 8%.
    If the periodic cap is 1% then
    the actual new interest rate will be 6% + 1% = 7%
ARMs which have an initial fixed period -- 30/3/1, 30/5/1, 30/7/1 and 30/10/1 -- can also have first adjustment cap. It limits the interest rate you will pay the first time your rate is adjusted. These ARMs are quoted as three numbers as in 5/2/5 which would mean that the first adjustment cap is 5%, adjustment cap thereafter is 2%, and the lifetime cap is 5%.

Two-Step loans -- 5/25 and 7/23 -- have only one adjustment after the first five or seven years of its term. They are quoted with a single first adjustment cap.


Profit earned from the sale of real estate. The new tax code does not tax the profits from the sale of a home if the proceeds are used to buy another house costing at least as much as the sales price of the old one.


Prohibits discrimination in any aspect of a credit transaction on the basis of race, religion, age, color, national origin, receipt of public assistance funds, sex, or marital status.


The value of a homeowner's unencumbered interest in real estate. Equity is computed by subtracting from the property's fair market value the total of the unpaid mortgage balance and any outstanding liens or other debts against the property. A homeowner's equity increases as he pays off his mortgage or as the property appreciates in value. When the mortgage and all other debts against the property are paid in full the homeowner has 100% equity in his property.


A stockholder-owned federally chartered corporation. Fannie Mae purchases residential home loans from mortgage lending institutions, packages the mortgages into securities and sells the securities to investors. The largest source of residential mortgage funds in the United States.


A loan insured by the Federal Housing Administration open to all qualified home purchasers. Interest rates on FHA loans are generally market rates, while down payment requirements are lower than for conventional loans. FHA loans cannot exceed the statutory limit.


For sale by owner.


Protects against damages caused to property by fire, windstorms, and other common hazards.


The assessed value of an owner-occupied residential property may be reduced by the amount of the exemption for the purposes of calculating property tax. Available in some states.


U.S. Department of Housing and Urban Development. Office of Housing/Federal Housing Administration within HUD insures home mortgage loans made by lenders and sets minimum standards for such homes.


That portion of a borrower's monthly payments held by the lender or servicer to pay for taxes, hazard insurance, mortgage insurance, lease payments, and other items as they become due.


A published measure of economic conditions usually relative to other financial instruments such as Treasury notes or Treasury bills. The lender uses a particular index to calculate the interest rate on an adjustable rate mortgage (ARM) by adding a fixed margin to the index. The most common indexes are:
  • Constant Maturity Treasury (CMT)
  • Treasury Bill (T-Bill)
  • 12-Month Treasury Average (MTA)
  • 11th District Cost of Funds Index (COFI)
  • London Inter Bank Offering Rates (LIBOR)
  • Certificates of Deposit (CD) Indexes


The relationship between the amount of the mortgage loan and the value of the real property expressed as a percentage. For purchase loans the value of the property is the appraised value or the purchase price, whichever is less. For refinance loans the value is the appraised value.

A LTV of 90% means that you can borrow a maximum of 90% of the property value. If a LTV exceeds 80%, a Private Mortgage Insurance (PMI) -- that insures the lender in the event a borrower defaults -- is generally required.

Downpayment is the difference between the purchase price and the mortgage amount.


A lender's promise to hold a certain interest rate and points for you, for a given number of days, while your loan application is processed. The interest rates quoted to you may stay the same, decrease, or increase from the day you apply for your mortgage. Lock-ins on rates and points might offer you a way to ensure that what you shop for is what you get.

However, a locked-in rate could also prevent you from taking advantage of rate decreases. If you think that rates will remain level or even go down, you may choose to bet on interest rates decreasing by electing to float until you go to closing.

Lock-ins of 30-60 days are common. If your lock-in period expires before you go to closing, you might lose the interest rate and the number of points you had locked-in. You may ask lender for a longer lock-in period. But bear in mind that lenders may charge you a fee for a longer lock-in period. Request information from the lender regarding lock procedures.


A lien or claim against real property given by the buyer to the lender as security for money borrowed. Under government-insured or loan-guarantee provisions, the payments may include escrow amounts covering taxes, hazard insurance, water charges, and special assessments. Mortgages generally run from 10 to 30 years, during which the loan is to be paid off.


A person (not an employee of a lender) who brings a borrower and a lender together to obtain a federally-related mortgage loan. A mortgage broker has access to a variety of lenders and often offers the most choice in loan programs. Mortgage brokers are paid a fee by the borrower or the lender when a loan closes.


Loans that do not comply with Fannie Mae or Freddie Mac guidelines. These guidelines establish the maximum loan amount, down payment, borrower credit and income requirements, and suitable properties. Loans that do conform to these guidelines may be sold to Fannie Mae or Freddie Mac.


Principal, Interest, Taxes and Insurance. These components are usually included in the monthly mortgage payment.


Payment of mortgage loan, or part of it, before due date. Mortgage agreements often restrict the right of prepayment either by limiting the amount that can be prepaid in any one year or charging a penalty for prepayment. Lenders who impose prepayment penalties will charge borrowers a fee if they wish to repay part or all of their loan in advance of the regular schedule. The Federal Housing Administration does not permit such restrictions in FHA insured mortgages.


The basic element of the loan as distinguished from interest and mortgage insurance premium. In other words, principal is the amount upon which interest is paid.


An insurance policy the borrower buys to protect the lender from non-payment of the loan.


Lenders use certain guidelines to determine a potential borrower's credit-worthiness. The two guidelines used are the housing and debt ratios. They are expressed as two numbers like 28/36 where 28 would be the housing ratio and 36 would be the debt ratio. It means that:
  1. Your housing expenses should not exceed 28 percent of your gross monthly income and
  2. Housing expenses plus long- term debt should not exceed 36 percent of your gross monthly income.
The housing expenses include monthly mortgage principal, interest payments, property taxes and homeowner’s insurance. There may be other expenses, such as condominium fees, homeowners fees, special assessments, etc., that are included. Long-term debt is defined as monthly expenses extending more than 10 months into the future. The qualifying ratios may vary from lender to lender.

Please note that qualifying ratios are only a rough guideline and underwriters consider many variables in their analysis. Many times, borrowers fall outside the guidelines, but have strong compensating factors that reflect low credit risk. Some compensating factors are history of savings, long-term job stability, a substantial down payment or excellent credit history will influence the decision to approve or deny a particular loan.


As generally used, the rights of ownership and possession of particular property. In real estate usage, title may refer to the instruments or documents by which a right of ownership is established (title documents), or it may refer to the ownership interest one has in the real estate.


Protects lenders or homeowners against loss of their interest in property due to legal defects in title. Title insurance may be issued to a "mortgagee's title policy." Insurance benefits will be paid only to the "named insured" in the title policy, so it is important that an owner purchase an "owner's title policy", if he desires the protection of title insurance.


A check of the title records, generally at the local courthouse, to make sure the buyer is purchasing a house from the legal owner and there are no liens, overdue special assessments, or other claims or outstanding restrictive covenants filed in the record, which would adversely affect the marketability or value of title.


A process of deciding whether to make a loan based on your credit reputation, income, debt, appraised value of the house and other factors.