With today's low interest rates, you may be giving more thought to refinancing your mortgage. However, before you determine if refinancing is a wise financial decision, you should familiarize yourself with the common terminology that comes with refinancing a home. Here are five common terms that you'll encounter along the way and how they'll be useful to you.
1. Adjustable Rate Mortgage
In an adjustable rate mortgage (ARM), the interest rate changes at intervals throughout the lifetime of the loan. Usually, ARMs start out at low interest rates to make them affordable, and then increase after 1, 3, or 5 years to a rate that is based on a nationwide average. After that, the interest rate will continue to change at preset intervals to remain in-line with the national index.
2. Fixed Rate Mortgage
This is the alternative to an adjustable rate mortgage. Fixed rate mortgages keep the same interest rate regardless of whether the nationwide interest average rises or falls, so you can plan on paying exactly the same amount every month for the entire term of the loan.
Points are up-front fees that you pay your lender at the time of refinancing. There are two different types of points:
- Discount points reduce the interest rate of your mortgage loan. Paid-for points could be useful if you plan to stay in your home for a long time, but you may lose money if you purchase points and then sell the house within a few years. Each point is equal to one percent of your loan amount.
- Origination points cover your lender's cost for putting your loan together. This fee varies between lenders, and it covers a variety of miscellaneous charges. These may include separate charges for the time your lender spends processing your application and preparing documents, as well as the cost of a professional appraiser who evaluates the market value of your house. You should compare origination fees before deciding on a lender.
4. Prepayment Penalty
This is an extra fee your lender might charge if you pay off your mortgage more quickly than the terms require. For example, many mortgage loans allow you to pay off up to 20 percent of your loan in a given year. If you choose to pay more than that by refinancing with a new lender, you may be charged an extra fee. Before you refinance your home, you should check your current mortgage to see if it contains any prepayment penalties.
5. Debt-to-Income Ratio
This is a number that lenders look at to determine whether you can make your mortgage payments. They add up all your regular monthly bills and divide that number into your monthly income. The result is a percentage, or ratio, that tells lenders how much risk they are taking when they lend you money. Usually, lenders prefer this number to be lower than 50 percent.
The first step to being a savvy financial consumer is becoming familiar with the language. When you are clear about the meaning of each term, you will feel empowered to identify the choice that is best for you and your family.
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