6 Loan Terms Every Investor Should Know

Apr
5
2019

Loan guidelines are constantly changing. It is essential to have a mortgage broker or loan officer you can contact to answer any questions you may have. It is also important to know as much about the process as possible. Regardless of your background applying for a loan can be an intimidating process. There are a handful of specific terms and practices that can be overwhelming at times. You don’t need to be an expert in every area, but you should know the basic topics. You can bet at some point in your real estate career you will apply for a loan and want to understand exactly what is going on. Here are six loan terms that every investor should know and understand.

  • Equity: Everyone is always concerned about how much equity they have in their property. The truth is most people don’t even know what it is. Simply put, equity is the difference between what is owed on your property and the current value. If you owe $200,000 and your home is worth $300,000 you have $100,000 in equity. The problem with equity is that it is a moving target. The only real way to determine value is by listing your home and seeing what a buyer will pay for it. Getting an appraisal done is reliable but is only a snapshot in time based on recent sales. With increased equity you can explore options for lines of credit or cash out refinance loans. Knowing your equity position at all times lets you know what kind of property you have and what you can do with it.
  • Debt To Income Ratio. It is not enough to generate a strong income for loan approval. You can make a million dollars a year, but if you are saddled with excessive debt you won’t get approved. It is truly not how much money you make but rather something called your debt to income ratio.  As the name indicates this is a formula that factors in your monthly debt in relation to your income. The lender adds up all the minimum monthly payments on your credit report as well as your proposed mortgage payment. They then divide that number by your gross monthly income. The number they come up with must be anywhere from 43-50% depending on the specific loan program. The bottom line is that making money is great, but if your debt obligation is too high you won’t get approved.
  • FICO Score: There are three main pillars to any loan approval: down payment (or equity), debt to income and credit score. You don’t need to be a lender to know the importance of a strong credit score. However, not everyone knows the specific jargon. FICO, originally called the Fair Isaac Company is the lead provider of credit scoring. There are three main bureaus that calculate credit scores: Experian, Equifax and Transunion. In most cases the scores they come up with will be pretty close to each other. However, one of the bureaus may have report something the others don’t, and the scores will be different. When your lender, or broker, asks what your FICO is, it is simply a quick way of asking for your credit score.
  • Loan To Value (LTV): As we stated, one of the pillars in any loan approval is your loan to value. If you are buying a property this would be your down payment divided by the purchase price. For a refinance this is the loan amount divided by the property value. These are important to know because different loans have different LTV guidelines. A loan for a three-family investment property may have a minimum LTV of 85%. This means that you need to come up with 15% down payment to buy the property. If you want to refinance you may be limited in the loan to value. This hamstrings the amount you can take out of the property and impacts whether the loan may be worth it for you.
  • Prepaid Escrows: Depending on the state your loan transaction is in you go may go into something called escrow when you close. This is not to be confused with your prepaid escrow amount. Your new lender always wants to hold your property taxes and insurance in advance. In most cases they want at least the next tax bill paid and possibly a cushion of a month or two as well. For the insurance you need to pay for the full year upfront prior to closing. These items are not to be confused with closing costs. They are not fees, rather taxes that must be paid in advance. The lender requires this so there are no worries about unpaid tax bills that can turn into tax liens.
  • Annual Percentage Rate (APR): One of the most confusing terms even for people in the industry in something called the APR.  The annual percentage rate on a loan is not the same as the simple interest rate. The APR calculates the annual cost of the funds over the term of the loan. On a loan you can have an interest rate of 5%, but an APR of say 5.33%. The only number that should matter to you is the simple interest rate. This is the number which determines your monthly payment and how much you are repaying on the loan.

There are literally dozens of specific terms and jargon words used on every loan transaction. These six will give you a basic understanding of what you are getting into.

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