Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail
Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

5 Key Terms You Must Know Before Getting A Mortgage

It's common knowledge that real estate agents and mortgage lenders are aliens.

They seem to appear out of nowhere, they all seem to know each other, and you never see them eat. They also have their own language, which you might hear them speak while you're at a closing or talking about a house.

If you're a mere mortal, you may never have their ability to appear at will or go so long without eating, but these five terms will help you learn to speak their language. Live long and prosper!

[And click on the term to read more about it in our Financial Dictionary.]

APR

Knowing a loan's annual percentage rate (or APR) tells you the true cost of borrowing because it includes all of the fees directly related to the loan, not just the interest payments. The fact that there is more than one way to calculate an APR complicates comparing loans, but the formula that includes the basic components is:

APR = [2 x Number of Payments per Year x Total Finance Charges] / [Original Loan Proceeds x Total Number of Payments + 1]

The responsibility of calculating APRs falls on the lender, not you, and federal regulations require lenders to disclose a loan's APR in large type. The Consumer Credit Protection Act of 1968 (also known as the Truth in Lending Act) requires lenders to disclose a loan's finance charges as well as its APR so you may compare loans.

APR calculations are based on fixed interest rates, so adjustable rates create ever-changing APRs. For these reasons, some borrowers turn to good-faith estimates from lenders to compare loan fees directly rather than compare the APRs.

ARM

An adjustable-rate mortgage (or ARM) has a varying interest rate that is calculated by adding a premium to a specific benchmark rate.

Two common types of ARMs are the interest-only ARM and the hybrid ARM. Interest-only ARMs offer a set period during which the borrower only pays the interest on the loan. This reduces the borrower's payment, but it leaves the principal outstanding. Hybrid ARMs offer a fixed rate for a period of time and then revert to a variable rate for the remainder of the loan's life. A 3/1 ARM, for example, carries a fixed rate for the first three years and then adjusts every year thereafter.

In many cases, ARMs have limits on how high and sometimes how low the rate can go, as well as how much it can move in any year, month or quarter. In some cases, the rate will only adjust up -- that is, you get no benefit if rates fall. Regardless, lenders are legally required to disclose how high your monthly payment might go. Be sure you can handle the worst-case scenario.

Freddie Mac

The Federal Home Loan Mortgage Corp. (FHLMC or Freddie Mac) is a government-sponsored entity that buys certain types of mortgages from banks and uses them as collateral for mortgage-backed securities.

Here's how Freddie Mac works:

  • If you get a mortgage, the lender agrees to transfer money to your account, and you agree to repay the lender according to a set schedule.
  • The lender may then choose to hold this mortgage in its portfolio or sell it in the secondary mortgage market.
  • By selling your mortgage, the lender receives cash that it can use to make more mortgage loans to other borrowers.
  • Because this process creates a steady supply of mortgage funds, mortgage rates stay competitive and mortgages are more available.

Thus, if your bank thinks that it can give you a loan that it knows Freddie Mac will buy, your bank is probably going to make the loan.

Freddie Mac packages the mortgages it buys into groups ("pools") with common characteristics (i.e., similar interest rates, maturities or credit ratings). It then sells securities that represent an ownership interest in these pools. These securities, called mortgage-backed securities, are bought by investors in the open market. With the funds from the sales, Freddie Mac buys more mortgages.
 
When you make your monthly mortgage payment to your lender or mortgage servicer, the lender or mortgage servicer keeps a fee and sends the rest of your payment to Freddie Mac. Freddie Mac in turn takes a fee and passes what's left to the investors who hold the mortgage-backed securities. For them, it's like owning a bond that is essentially guaranteed by the government.
 
That's because Freddie Mac guarantees the timely payment of interest and principal on its mortgage-backed securities -- in other words, if you don't make your mortgage payments, Freddie Mac still makes its payments to the investors.

Ginnie Mae

Freddie Mac is not the only government-sponsored entity involved in mortgage lending. An agency of the U.S. Department of Housing and Urban Development, the Government National Mortgage Association (GNMA or Ginnie Mae) was established by Congress in 1968. The agency guarantees the timely payment of interest and principal on certain mortgage-backed securities.

Unlike Freddie Mac, however, Ginnie Mae doesn't buy or sell mortgages, nor does it issue mortgage-backed securities. In general, it guarantees only those mortgage-backed securities that are made up of mortgages insured by the Federal Housing Administration, the Department of Veterans Affairs, the Rural Housing Service or the Office of Public and Indian Housing.

Qualified Mortgage Insurance Premium

A qualified mortgage insurance premium insures a homeowner’s mortgage payments. Mortgage insurance typically comes from the Federal Housing Administration, the Department of Veterans Affairs, the Rural Housing Service or a private mortgage insurer.

You may be required to buy it if your down payment is less than 20% of the home price. Basically, the policy kicks in if you default on the loan. That way, the bank still gets its loan payments. Qualified mortgage insurance premiums may be tax deductible if the mortgage originated after 2006, though there are income limits.

The Investing Answer: We've armed you with some basic knowledge about mortgage terms, but there's much more to learn. Check out our Financial Dictionary for more. 

And of course, there's nothing more important in buying a mortgage than getting the best rate. Use our helpful tool below to find the best mortgage rates in your city.