Real Estate Financing Terms

Why This Matters

Real estate financing isn't just about getting a loan—it's about understanding the interconnected system of risk assessment, cost structures, and payment mechanics that determine whether you can afford a property and how much it will actually cost you over time. You're being tested on your ability to analyze how lenders evaluate borrowers, how loan structures affect total costs, and how the various fees and protections work together to facilitate (or complicate) property transactions.

The terms in this guide fall into distinct conceptual buckets: borrower qualification metrics, loan structure options, cost components, and transaction safeguards. Don't just memorize definitions—know which terms relate to risk assessment, which affect monthly payments, and which protect lenders versus borrowers. When you see an exam question about financing, ask yourself: "Is this about qualifying for the loan, structuring the loan, or closing the deal?"

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Borrower Qualification Metrics

Lenders need to answer one fundamental question before approving a loan: Can this borrower reliably repay the debt? These terms represent the key ratios and thresholds that quantify borrower risk.

Loan-to-Value Ratio (LTV)

• Compares loan amount to property value—calculated as $\text{LTV} = \frac{\text{Loan Amount}}{\text{Property Value}} \times 100$
• Higher LTV means higher risk for lenders, often triggering PMI requirements and higher interest rates
• 80% LTV is the critical threshold—below this, borrowers typically avoid PMI and secure better terms

Debt-to-Income Ratio (DTI)

• Measures monthly debt obligations against gross income—expressed as a percentage of income consumed by debt payments
• Lenders typically prefer DTI below 43% for qualified mortgages, though some programs allow higher ratios
• Includes all recurring debts—not just the proposed mortgage, but also car loans, student loans, and credit card minimums

Down Payment

• Initial cash investment expressed as a percentage of purchase price—directly affects LTV
• Larger down payments reduce LTV, potentially eliminating PMI and lowering interest rates
• Requirements vary by loan type—conventional loans often require 5-20%, while FHA loans may accept 3.5%

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Loan Structure and Payment Mechanics

Once approved, borrowers must choose how their loan is structured. The structure determines payment predictability, total interest costs, and flexibility over the loan's life.

Mortgage

• Legal agreement securing debt with property—the property serves as collateral, giving lenders recourse if payments stop
• Monthly payments typically include principal, interest, taxes, and insurance (often called PITI)
• Default triggers foreclosure—the lender's ultimate protection against non-payment

Principal

• The original borrowed amount, excluding interest—this is what you actually owe
• Payments gradually reduce principal over time, building equity in the property
• Early payments are interest-heavy—in a standard amortization, most early dollars go to interest, not principal

Amortization

• Systematic loan repayment through scheduled payments—each payment covers both interest and principal reduction
• Amortization schedules show the split between principal and interest for every payment over the loan term
• Front-loaded interest means borrowers pay more interest in early years, more principal in later years

Interest Rate

• The cost of borrowing, expressed as an annual percentage of the outstanding balance
• Determines total loan cost—even small rate differences compound significantly over 15-30 years
• Influenced by credit score, market conditions, and loan type—borrowers with stronger profiles secure lower rates

Fixed-Rate Mortgage

• Interest rate locked for entire loan term—payments remain constant regardless of market fluctuations
• Provides payment predictability, making long-term budgeting straightforward
• Common terms are 15 and 30 years—shorter terms mean higher payments but less total interest

Adjustable-Rate Mortgage (ARM)

• Interest rate fluctuates based on market index—typically tied to benchmarks like SOFR or Treasury rates
• Initial "teaser" rates often lower than fixed rates, but can increase substantially after adjustment periods
• Rate caps limit increases—periodic caps restrict single adjustments, lifetime caps limit total increases

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Transaction Costs and Fees

Beyond the loan itself, real estate transactions involve numerous fees that add to the buyer's total costs. These costs typically range from 2-5% of the purchase price and are paid at closing.

Closing Costs

• Aggregate fees paid when finalizing the transaction—due at the closing table, not spread over the loan
• Include origination fees, title insurance, appraisal fees, and attorney fees among others
• Typically 2-5% of purchase price—a $400,000$ home might have $8,000-20,000$ in closing costs

Origination Fee

• Lender's charge for processing the loan application—covers underwriting, documentation, and administrative costs
• Usually 0.5-1% of loan amount—negotiable in some cases
• Distinct from points—origination fees are processing costs, points are optional rate buy-downs

Points

• Prepaid interest used to buy down the rate—one point equals 1% of the loan amount
• Trade-off between upfront cost and long-term savings—paying points makes sense for long-term ownership
• Break-even analysis determines value—calculate how long it takes for monthly savings to exceed point costs

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Risk Mitigation and Protections

Real estate transactions involve substantial risk for all parties. These terms represent the mechanisms that protect lenders, buyers, and sellers from various transaction risks.

Private Mortgage Insurance (PMI)

• Protects the lender (not the borrower) if a low-down-payment borrower defaults
• Required when LTV exceeds 80%—automatically triggered by down payments below 20%
• Can be canceled at 20% equity—borrowers should track their equity to eliminate this cost

Escrow

• Third-party account holding funds until conditions are met—creates neutral ground between transaction parties
• Used for earnest money during purchase and ongoing tax/insurance payments after closing
• Protects both parties—sellers know funds exist, buyers know funds won't release prematurely

Title Insurance

• Protects against ownership defects—covers losses from liens, encumbrances, or competing ownership claims
• One-time premium paid at closing—unlike other insurance, not an ongoing cost
• Lender's policy required, owner's policy optional—lenders protect their collateral interest

Underwriting

• Lender's risk evaluation process—the comprehensive review determining loan approval or denial
• Examines credit history, income verification, assets, and property value—holistic borrower assessment
• Results in approval, denial, or conditional approval—conditions might require additional documentation

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Equity and Long-Term Ownership

As borrowers make payments and property values change, their ownership stake evolves. These terms describe how homeowners build wealth and access value in their properties.

Equity

• Market value minus outstanding mortgage balance—represents your actual ownership stake
• Builds through principal payments and property appreciation—both reduce your leverage
• Can be accessed through refinancing or home equity products—equity is wealth that can be mobilized

Refinancing

• Replacing existing mortgage with new loan—essentially starting over with different terms
• Common reasons include lower rates, shorter terms, or cash-out—each serves different financial goals
• Involves new closing costs—must calculate whether savings exceed refinancing expenses

Appraisal

• Professional property valuation—conducted by licensed appraiser using comparable sales and property condition
• Required by lenders to verify collateral value—ensures loan amount doesn't exceed property worth
• Protects against overpaying—if appraisal comes in low, buyers can renegotiate or walk away

Foreclosure

• Legal process where lender seizes property—triggered by sustained payment default
• Devastating credit impact—remains on credit report for seven years, severely limiting future borrowing
• Process varies by state—judicial foreclosure requires court action, non-judicial does not

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Quick Reference Table

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Self-Check Questions

1. A borrower has a $350,000$ home with a $280,000$ mortgage balance. Calculate the LTV and determine whether PMI would be required on a new loan at this ratio.

2. Compare and contrast how fixed-rate mortgages and ARMs affect a borrower's risk exposure over a 30-year loan term. Under what circumstances might each be the better choice?

3. Which two ratios do lenders primarily use to assess borrower qualification, and what specific risk does each ratio measure?

4. Explain the relationship between down payment size, LTV, and PMI requirements. How does increasing the down payment create a cascade of benefits for the borrower?

5. A borrower is deciding whether to pay 2 points to reduce their interest rate by 0.5%. What calculation should they perform, and what factors determine whether paying points makes financial sense?