Unless you plan to pay all cash for your home, you’ll need to secure a mortgage before you can call that dream home your own.
But the mortgage process is chock-full of confusing terms, and at times you may think you need a Rosetta stone to help translate them.
There’s no need to panic. Here are seven of the more complex mortgage terms to know. Once you understand the lingo, you’ll be able to navigate the home loan application process with ease.
Your debt-to-income, or DTI, ratio is one of the most basic equations mortgage lenders will use to figure out how much money they will let you borrow, or even if they will approve you for a mortgage, period. It compares how much money you owe (on student loans, credit cards, auto loans and any other debts) to your income. Say you make $5,000 a month but spend $1,000 a month paying off a car loan, a student loan and the minimum payments on your credit cards. Divide $1,000 by $5,000 to get a DTI of 0.2, or 20 percent.
Now add to your total debt how much money you would potentially pay each month for a home loan. Let’s say the home you want would cost you an additional $1,000 a month; your DTI would then jump to 40 percent. For a conventional mortgage, most lenders prefer a borrower’s DTI to be no more than 36 percent, including the mortgage payment (although some lenders will accept up to 43 percent). The higher your DTI, the greater a lending a risk you’re perceived to be by the loan provider.
EARNEST MONEY DEPOSIT
Your earnest money deposit, also known as earnest money or EMD, is the cash you put down to prove to a home seller that you’re serious — or earnest — about buying their house. When you close on the home, this deposit is applied to your down payment. Earnest money is usually held by a title company or in a real estate broker's escrow account. If the sale doesn’t go through, the seller generally gets to keep the money.
RELATED CONTENT: Want to learn more about this topic? Our complete guide to buying a home can help you prepare for one of the largest purchases you’ll ever make.
Home sellers rarely accept offers without the buyers putting down earnest money. On average, you can expect to hand over 1 percent to 2 percent of the total home purchase price — though in housing markets with high demand, home sellers may ask for a 2 percent to 3 percent deposit.
The loan-to-value, or LTV, ratio is the amount of money you borrow from a lender divided by the purchase price of the home you want to buy, expressed as a percentage. Let’s say you're making a $100,000 down payment and will need to borrow $300,000 to purchase a $400,000 home. Divide $300,000 by $400,000, and you’ll get an LTV ratio of 0.75, or 75 percent.
To obtain a conventional mortgage, most mortgage lenders require borrowers to have an LTV ratio of 80 percent or lower. Why? Because the higher a borrower’s LTV ratio, the greater the odds are that the person may stop making their mortgage payments and default on the loan.
Mortgage preapproval is a pivotal step in the mortgage application process that should take place before you start seriously shopping for a house. To determine whether to preapprove your mortgage, a lender will probe into your financial records to assess your fiscal responsibility. This includes reviewing your income via W-2 tax forms, tax returns and your credit score and credit report, as well as paperwork on any other major financial holdings you hold, including properties or investments (e.g., CDs, IRAs, individual stocks or bonds). You’ll also need to provide proof of funds for your down payment; this may simply be a checking or savings account statement showing where the down payment money is being stored. Many home sellers will accept an offer only from a buyer who has been preapproved for a mortgage.
Many homebuyers get mortgage preapproval confused with prequalification, but these terms are significantly different. Mortgage prequalification only requires a basic overview of your finances by a mortgage lender to determine how much of a loan you may qualify for. You provide a lender with information about your down payment, income, assets and debts, but you don't need to produce any paperwork, such as bank statements or tax returns, to back it up.
Getting prequalified, therefore, can be a good way to get a ballpark figure of how much a lender may be willing to loan you. But it’s not a guarantee for getting a mortgage, as it’s only based on a cursory review of your finances — to get that, you need to go through the mortgage preapproval process.
Mortgage lenders throw around this acronym a lot. PITI stands for principal, interest, taxes and insurance, and it’s what makes up your total mortgage payment each month. Your principal reflects the amount of money you’re actually borrowing. Interest is the fee you pay each month to your lender, and how they make most of their money. Taxes are the property taxes you’ll have to pay to your local government, based on your home’s assessed value. Last, insurance includes the homeowners insurance you pay to protect your property, and may also include private mortgage insurance (more on that below).
If you put less than 20 percent down for a conventional mortgage, you’ll typically be required to pay private mortgage insurance, or PMI. This is an extra monthly fee designed to mitigate risk to the lender. Lenders consider homebuyers who put less than 20 percent down as more likely to default on their mortgage, so they try to protect themselves by charging this extra insurance. PMI ranges from about 0.3 percent to 1.15 percent of a home loan. The good news? After you’ve gained 20 percent equity in your home, you can proactively ask your lender to cancel your PMI. Once you reach 22 percent equity, your lender must cancel your PMI.