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Financing Terminology

If you have any questions about any of these items or if you have some financing terminology that we didn't include, please let us know. Use the "Contact Us" link above.

Mortgage Financing Terminology:

• PITI - Principal, Interest, Taxes, Insurance

• PMI, MIP, VA Funding Fee

• Escrow Account

• LTV - Loan to Value

• Seller Concession

• Pre-Qualification vs. Pre-Approval

• GFE - Good Faith Estimate and HUD-1 Settlement Statement

• APR - Annual Percentage Rate

PITI

PITI stands for Principal, Interest, Taxes & Insurance - in essence it represents your total monthly mortgage payment.

• Principal = pay down on mortgage - Although the majority of your initial mortgage payments for 10+ years is interest, a portion of each of your payments goes to paying down the mortgage balance. This is called the principal payment.

• Interest = profit to the bank - This is the payment to the bank or other lending institution for lending you the money. It sometimes doubles the cost of buying a home if you continue to make payments over a 30 years period. It is wise to make extra principal payments on a regular basis in order to pay off the loan early and reduce the total interest that is paid. Also, interest is tax deductible for home owners who itemize their income taxes.

• Taxes = city, town, state, school real estate taxes - Sometimes the total of real estate taxes in a given location is a major burden on home buyers and can greatly decrease the amount of a mortgage the home buyer can afford. Real estate taxes also are tax deductible if you itemize your income taxes.

• Insurance = fire/liability & PMI or MIP - The insurance aspect includes both the fire and liability (home owners insurance) as well as Private Mortgage Insurance (PMI for conventional loans with less than 20% down) and Mortgage Insurance Premium (MIP for FHA loans regardless of down payment). See below for additional information on PMI and MIP.

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PMI & MIP

Regardless of the mortgage product you are using, if you are putting less than 20% down, you will be required to pay some sort of "insurance" to lower the risk to the bank.

• PMI - Private Mortgage Insurance

  This is used when you are obtaining a conventional mortgage loan. The rate you pay will be based on your credit score and amount of your down payment. The more down and the higher your credit score the lower your rate. It also can be paid as an upfront fee or a combination of upfront and monthly or monthly.

  PMI is obtained from special insurance companies who deal with such risks. The lender will require you to have PMI at closing. Sometimes a borrower will be approved by the lender but not be able to get approved for PMI. In those cases, the borrower will need to come up with more money at closing to reach the 20% down goal in order to eliminate the need for the PMI.

  PMI automatically drops off when the equity in the property (as measured by subtracting the current balance of the loan from the original appraisal value of the property) reaches 22%. You can also request the dropping or the PMI premium if you believe that the equity has reached 22% due to improvements you have made or a general upswing in the values of all properties in your area.

  Check out this discussion of Private Mortgage Insurance.

• MIP - Mortgage Insurance Premium

  This is used when you are getting an FHA loan. Regardless of how much you are putting down, you will be required to pay MIP if you are using FHA financing. It is an upfront fee plus a monthly fee. The upfront MIP amount can be added to the mortgage and financed if you don't have the cash to pay it.

• VA Funding Fee - For Veterans Administration Loans

  This fee is based on the veterans type of service, the down payment, and whether or not they have used the program previously or not. The fee is paid upfront and ranges from 1.25% to 3.3% of the mortgage amount. The fee can be paid in cash at closing or financed into the mortgage amount.

The official website for the VA Loan Program is: www.homeloans.va.gov

You can check out the VA funding fee requirements at www.vafundingfee.com.

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Escrow Account

The escrow account is actually a savings account of sorts that is part of the mortgage. It is usually required when you are putting down less than 20% and borrowing 80% or more. The reason for this is that lending institutions hate risk. If you are putting a small down payment into the deal, you have very little risk and might not pay the real estate taxes when due or the home owners insurance when it is due. The local municipality could foreclose on the home and wipe out the mortgage or the home could burn down without insurance and the bank would only have the land to collateralize the loan. Either way the bank loses.

But if you have at least 20% down, you have something to lose and the risk of loss is transferred to you. So with at least 20% down the bank will probably initially waive the escrow requirement, although they will have you sign an agreement allowing them to institute the escrow requirement at a later time. This is to protect the bank in the event you don't make these payments when due.

Generally the bank or lending institution will have another company administer this account. You generally will be charged a setup fee at closing called a "tax service fee" or similar name of around $75 or so to set up this account. You also will receive interest on the funds sitting in your account which will be added to the escrow account as earned and for which you will receive a 1099 each year for misc. interest earnings. Don't expect much, this interest usually amounts to 1/2% to 1%.

How does an escrow account work?

• An amount is determined at closing that needs to be set into the account initially in order to have enough money, along with the monthly escrow payment, to pay the taxes and insurances when they are due. You will receive a copy of this calculation at closing and this is part of your closing costs.

• 1/12th of the real estate taxes and insurance are deposited each month as part of your mortgage payment. The PITI monthly mortgage payment is split into the P & I, Principal and Interest, which the bank keeps; and the T & I, Taxes and Insurance, which is sent to the escrow servicing company.

• The taxes and insurance are paid out of the escrow account when they come due by the escrow servicing company.

• An escrow analysis is usually conducted annually to determine if there is enough funds in the account to pay taxes and insurance in the future. If too much is in the account, you will be given the option to receive a check for the surplus. If the account is short you will be asked to pay a lump sum payment to bring the account current or spread the amount over the next 12 months plus an increased monthly payment to put more money into the account to cover the increase in real estate taxes or home owners insurance that probably caused the shortgage.

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LTV - Loan To Value

LTV stands for Loan to Value. You take the amount of the mortgage loan you are borrowing and show it as a percentage of the purchase price.

For example:

• Purchase Price = $100,000
• Down Payment = 10%
• Mortgage Loan = $90,000
• The LTV = 90% = $90,000/$100,000

Another example:

• Purchase Price = $100,000
• Down Payment = 25%
• Mortgage Loan = $75,000
• The LTV = 75% = $75,000/$100,000

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Seller Concession

A Seller Concession is a seller contribution/credit at closing towards your closing costs.

FHA has allowed up to 6% of the purchase price as a seller concession, but is in the process of lowering the maximum to 3% of purchase price. Most mortgage loan programs only allow up to 3% maximum contribution/credit at closing from the seller.

Example:

• Purchase Price = $200,000
• Maximum Seller Concession = 3%
• Maximum Seller Concession = $6,000 ($200,000 x 3%)

But, who really pays? Is the seller actually giving you something for free? Hardly!!!

Here is the reality.

• Seller asking $200,000
• Seller Would Accept $195,000
• Buyer needs $5,000 Towards Closing Costs
• Buyer offers $195,000 with $5,000 Concession
• Seller Would Net $190,000 ($195,000 - $5,000)
• Seller Counter-offers $200,000 with $5,000 Concession
• Seller Would Net $195,000 ($200,000 - $5,000)
• Buyer Pays $200,000 with $5,000 Concession
• Mortgage is Based on $200,000 not $195,000

Who paid the $5,000 concession? The buyer of course. It was included in the purchase price and the mortgage. The buyer is now paying it back over 30 years with interest.

There is a better way. Come up with the cash yourself.

• Use the money in a retirement plan (401k or IRA). These plans usually allow you to borrow the money from the plan without a penalty and then pay it back to yourself.

• Sell something. Perhaps you have an extra car or a boat or some collectibles that the proceeds from would be better utilized on buying a home.

• Borrow from your relatives. I know, this is a tough one. You are independent and don't feel that borrowing from a parent or sibling or uncle is what you should do. However, it has been my experience that parents in particular will bend over backwards to help their children or grandchildren buy a home. Owning your own home is a great financial move and shows maturity and willingness to settle down and put down roots. These are worthy goals that most relatives, if they are able, will help you attain.

• Borrow from your employer or ask for an early bonus. I've had several situations where a valuable employee was rewarded by their employer with a bonus in order to help them buy a home. Employees who own their own home tend to be more stable and make better employees. This is particularly the case with a small business.

Another aspect of asking for seller concessions is your negotiating strength. By asking for seller concessions, especially maximum concessions, you are sending a signal to the seller that you may be a financial risk and that you might not be able to get a mortgage.

Sellers basically have only two thoughts when selling a home. Is the buyer willing to pay the price I want and is the buyer able to get a mortgage and close. Asking for a seller concession places doubt in the seller's mind.

On the other hand, if you come in with a "clean" offer, that is not asking for a seller concession or other out of the ordinary requests, you appear stronger in the eyes of the seller. Your agent, on your behalf, ends up negotiating from a stronger position and often will get additional concessions on price, for example, then would otherwise have been possible.

So, bottom line, use seller concessions if you must. But, explore other options to fund your closing costs first, before putting such a request into an offer.

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Pre-Qualification vs. Pre-Approval

A Pre-Qualification really is just a personal opinion by whomever is giving the Pre-Qualification as to your ability to obtain a mortgage and for how much.

A Pre-Qualification:

• Generally involves one or two credit reports, not all three.
• Income is checked by looking at pay stubs not verifying the source(s).
• Rarely is anything else checked.

The worth of a pre-qualification is based on the reputation of the person or entity giving the pre-qualification. Sometimes it isn't worth the paper it is written on.

A Pre-Approval:

• Involves a full verification of employment, assets, and income.
• Credit is pulled from all three credit reporting agencies.
• Income tax returns, W-2’s, etc., are checked.

A Pre-Approval is generally subject only to getting a home under contract and the home appraising for at least the purchase price.

Many lending institutions won't issue a mortgage Pre-Approval as it takes more effort and it is against their policy to take an application until you have a property under contract.

Keep looking. Find a lender who is willing to issue a Pre-Approval. They may require you to pay an application or credit report fee. It is worth paying for a Pre-Approval as it strengthens your negotiating position.

As a seller, which would you prefer for a buyer to have?

• Pre-qualification? = a personal opinion
• Pre-approval? = a mortgage commitment

Buying a home is very much about negotiating strength. Give yourself every tool you can to increase your negotiating strength. You will be rewarded with a better deal on a home.

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GFE and HUD 1

A "GFE" is a Good Faith Estimate of closing costs. It is used to compare costs of different loans. It doesn't include all costs associated with buying a home, such as the cost for home inspections, personal attorney, title insurance, or repairs.

A "HUD 1" is the official document that the Department of Housing and Urban Development (HUD) requires the closing agents to fill out and have the seller and buyer sign at closing that shows the actually purchase price and closing costs being paid by each at closing.

It is required that you be given an official GFE upon actual application for a loan. Home closing procedures are covered under a federal act - RESPA - the Real Estate Settlement Procedures Act.

From the HUD website, "RESPA is about closing costs and settlement procedures. RESPA requires that consumers receive disclosures at various times in the transaction and outlaws kickbacks that increase the cost of settlement services. RESPA is a HUD consumer protection statute designed to help homebuyers be better shoppers in the home buying process, and is enforced by HUD."

To see a copy of the new GFE, Good Faith Estimate, click here.

To see a copy of the HUD 1, Settlement Statement, click here.

The rules are now stricter with regard to giving you a Good Faith Estimate. Because the lender is held more accountable for the figures they put on the form, you probably won't get one until you actually apply for a mortgage. However, it is important to get some type of cost estimate earlier from a lender so that you know about how much cash you will need for your home purchase for down payment and closing costs.

Actual costs at closing should be very close to the estimates. Make sure to compare the GFE you get to the HUD 1 before closing. Either your attorney, your closing agent, or your buyer agent should be able to help you compare the costs. If there are differences that seem out of line, bring them to your lender's and closing agent's attentions right away. Don't wait until closing. You want the closing to go smoothly and as such you want to handle such issues earlier.

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APR

APR refers to Annual Percentage Rate. When checking out different mortgage loans and after comparing the GFE or other closing cost estimates you will notice that there are some “fixed” costs that won’t vary between banks. These would include items such as recording fees, transfer tax, mortgage tax, flood certification fee, and credit report fee.

But you will also notice that there are “variable” costs that will differ between banks. They refer to these by many different names such as: commitment fee, settlement fee, underwriting fee, document prep fee, bank attorney fee, etc.

The federal government came up with a way to compare loans that takes into account these differences. It is called the APR, or Annual Percentage Rate. The APR will be higher than the “note rate”. The “note rate” is the actual interest rate you are paying. The APR uses that rate but adjusts it to include the closing costs for that loan.

Although the actual APR calculation is a little more complex than this explanation, it should give you a basic idea of how it works. Basically the way the APR is calculated is they take the amount you are borrowing and subtract off your closing costs to arrive at the actual net amount you in theory are borrowing. They then take the monthly payment based on the note rate and term of the loan and recalculate the interest based on the new net adjusted balance they calculated. In essence they back into a new interest rate. That rate is the APR.

Calculate your own APR, download free APR calculation software by clicking here.

For more information about shopping for a mortgage, check out HUD's publication, "Looking for the Best Mortgage".

Also, check out HUD's website, "Shopping for a Loan".

And, check out HUD's "revised" Settlement Costs Booklet.

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