Understanding Home Loan Terms

Key takeaways

• The difference between a home equity line of credit (HELOC) and a home equity loan (HEL) is that a HELOC works as a line of credit, whereas the HEL provides a lump-sum amount upfront.

• A cash-out refinance, another loan-based option, replaces an existing mortgage with one of a higher amount; the borrower takes the difference as cash.

• The loan-to-value ratio is a metric that lenders use to determine how much money they can loan to a homeowner based on the home’s fair market value.

• Borrowers need to understand basic terms such as principal amount, interest rate, total interest and maturity date to evaluate the overall impact of the loan on their finances.

• Loans based on amount of equity in a home often require borrowers to offer their property as collateral to protect the lender in case the borrower is unable to repay the loan.

A recent Financial Industry Regulatory Authority (FINRA) Foundation study showed adults answered only half of financial literacy questions correctly. However, 71% of these respondents claimed to have strong financial literacy. For homeowners considering a loan option in order to access liquidity, financial literacy is crucial. Prior to taking the step into such a loan, you may benefit from a refresher on key terms you are likely to encounter during the process.

Common terms you’ll see during the loan process

The loan process contains many technical and industry-specific terms that may be difficult to follow without finance, real estate or legal background. However, understanding basic industry terminology can help you make informed decisions.

Cash-Out Refinance

A cash-out refinance is a particular type of refinancing where a new mortgage – of a larger amount – replaces an existing mortgage. In borrowing a larger principal sum, you receive the difference as cash (i.e., the cash-out) during closing. Borrowers typically consider a cash-out refinance as an option when they have equity in their home but lack cash to pursue other financial goals or to take care of financial obligations.

Closing costs

Applying for a loan to tap into your home equity is not free. Lenders will often charge borrowers for different expenses associated with completing the transaction. Known as closing costs, they are usually within a few percentage points of your loan’s value and generally include payment for the following:

• Mortgage broker fees (fees paid to a third party for procuring the mortgage for you)

• Loan application fee

• Credit reports

• Title search and title insurance fees

• Loan origination and underwriting

Home appraisal

Depending on the lender, you will either pay the closing costs for your refinance upfront, or you may have the option of rolling the costs into the overall value of your loan.

Credit score

A credit score is a three-digit number that represents a person’s creditworthiness. In other words, a measure of their ability to repay a loan or other financial obligation. Several companies compile credit data to generate scores using key information including:

• Income

• Debt-to-income ratio

• Debt repayment history

• Amount of current debt

Your credit score is important in the home loan industry because it influences the qualifying terms for your loan, including the amount, maturity date and interest rate.

Fair market value

A home’s fair market value (FMV) is the price that a person could sell a home for on the open market under normal conditions. Your home’s FMV plays an important role in the loan process because it directly ties to the amount of equity you have and the size of the loan you could receive. Different methods exist for calculating a home’s FMV, which may include:

• Recent sales of comparable homes in the area

• Independent appraisals

• County or local government appraisals for property tax purposes

Home equity line of credit

If you are looking to tap into your home equity, one option is a HELOC. A HELOC has distinct characteristics. Much like a credit card, a HELOC gives you access to a line of credit that you may use with flexibility (i.e., you don’t have to withdraw the cash proceeds in one transaction). A HELOC can be useful in situations where the homeowner is not sure of just how much they’ll need, and when.

Home equity loan

Another option is a home equity loan (HEL). When you take out a home equity loan, you receive a lump sum upfront, typically up to 80-90% of the equity you have in your home. You then repay that amount in monthly installments plus interest.

Loan-to-value ratio

Loan-to-value (LTV) ratio is a percentage that reflects the amount of your home equity loan compared to its FMV. Lenders will rely on this figure to avoid overextending credit to a borrower. Generally, lenders are willing to extend debt to a homeowner so long as the amounts of loans tied to the property do not exceed an LTV ratio of 80%. This percentage ensures a homeowner still has 20% equity in the home after closing on the loan, which provides some assurance to the lender in the event of a market downturn or a borrower’s default.

Other key terms in many agreements for loans based on home equity

Prior to closing, you will receive an agreement that will state all the rights and obligations of the borrower and the lender. Below are some of the general terms that appear in most agreements. However, borrowers should always consult with a lawyer or other trusted representative to understand the specific parts of their agreement and answer any related questions.

Principal amount

The principal amount refers to the initial borrowed amount of the loan. This term is essential for understanding the impact of a loan on a person’s finances. The figure influences the amount of interest that will accrue, and represents the amount of debt a homeowner is initially agreeing to undertake.

Interest rate

Second to the principal amount, the interest rate is the next-most important term to identify and comprehend in a home loan agreement. The interest rate is a percentage that determines how much interest will accrue on the loan over a certain period.

Generally, interest rates are fixed or variable. Fixed interest rates do not change at all over the duration of the loan repayment. This feature provides the benefit of certainty when it comes to projecting cash-flow needs. Variable, or adjustable, rates, in comparison, can change based on market conditions. This can create swings in your repayment amounts over time.

Total interest

In the short term, the interest accrued on a home loan may seem minimal. However, that number can be deceiving because it does not reflect the total interest. A home loan’s total interest is the entire amount of interest that a borrower will pay over the loan’s lifespan. Borrowers should calculate this number early on to fully understand the total cost of the loan and its impact on long-term finances.

Maturity date

The maturity date is the anticipated day when the borrower will repay the loan in full based on the applied principal amount and interest rate. Borrowers can find the maturity date for their loan by using an amortization schedule, usually available from the lender. Over time, a loan’s principal balance will decrease as payments are made, which will lower the accrual of interest. Variable rates, forbearance periods and other factors can sometimes alter a loan’s maturity date.

Collateral

Most lenders will require borrowers under an equity-based loan to offer their house as collateral as a condition of the loan. Collateral – a security interest – is a way for lenders to obtain reassurance that they will be able to recover borrowed funds if a homeowner is unable to repay their loan in the future.

During the loan process, lenders will submit a financing statement with the Secretary of State where the transaction takes place, and execute a security agreement with the borrower. These items allow the lender to take a security interest in the property. Under certain circumstances, such as nonpayment, the lender can usually take action to recover any owed amounts (e.g., foreclosure and sale of the collateral).

Default

A default is when the borrower of a loan breaches the contract by failing to make timely repayment or failing to follow other conditions of the loan. A loan contract will usually explain what events could trigger a default and will likely detail the process, rights and obligations for both the lender and homeowner.

In the event of a default, the lender will send a notice to the borrower and seek repayment. The borrower can cure the default by paying any owed amounts. Otherwise, the lender will initiate foreclosure proceedings per terms of the contract.

Guaranty

In addition to collateral, lenders may require a borrower to make a guaranty on the loan to provide further assurance and recourse in the event of a default. A guaranty creates a personal obligation to another party to repay the borrowed amount under a loan, along with any outstanding interest or other charges. Guarantees may be more common in situations where borrowers present an increased risk for default.

Balloon payment

You may be familiar with standard loan repayment terms from experience with credit cards, student loans or your mortgage. Usually, the process involves monthly repayment installments of principal and interest until the loan’s maturity date. Some loans, however, including some equity-based loans, have the potential for a balloon payment.

With a balloon payment, borrowers may have low or even zero-amount repayment installments during the first stages of their loan. The loan agreement will then require repayment of all or a substantial part of the loan on a future date. This larger payment is the “balloon.” The balloon payment structure can be helpful for borrowers who have cash-flow needs early in the life of the loan, but it increases the risk of default if they are unable to meet the repayment demands later.

Prepayment penalties

Prospective borrowers should also look for any prepayment penalties when considering a loan. Some lenders will impose these on borrowers who wish to fully repay their loan prior to its maturity date.

The existence of prepayment penalties can be difficult for borrowers to understand because they believe lenders should not punish them for repaying their loans early. However, lenders are in the business to make money, which they do through the collection of interest on the principal amount. A prepayment penalty is a way for the lender to recoup some of the lost revenue from the interest that would have otherwise accrued.

Compare your loan options with a home equity agreement

You may be curious about alternatives to equity-based loans as you research key terms, and consider the overall value a loan may provide for your financial situation. One alternative for homeowners looking for a way to utilize their equity without additional debt is a home equity agreement (HEA).

Unlike a loan, a HEA is where you sell equity in your home to a home equity agreement provider – such as Unlock Technologies – in exchange for cash proceeds. The amount you receive in cash proceeds will depend on your home’s value and the amount of equity you have in it. Benefits of HEAs include:

• No loan (which means no monthly repayments of principal and interest)

• Flexibility in repayment

• Lower credit score minimum requirements compared to traditional loans

The term of a HEA is typically 10 years, which gives you a couple of options for repaying the HEA provider. One is to sell the home within that period and pay the equity percentage to the provider with the proceeds. Alternatively, you can buy out the ownership interest. The HEA provider would obtain an appraisal of your home’s FMV to determine the buyout amount based on its ownership interest.

It’s easy to apply for a HEA with Unlock Technologies

The loan process contains many industry-specific terms that are important to understand before signing on the dotted line. Doing the necessary research in advance helps you avoid financial pitfalls and other surprises. Carefully read and understand all terms of related agreements and seek professional help when questions arise.

You also may realize that a HEA provides a better alternative than a loan when you want to tap your home equity.

Contact Unlock Technologies today to see options for using your home’s equity.