Terminology for Real Estate Finance Documents

Instructor: Ian Lord

Ian is a real estate investor, MBA, former health professions educator, and Air Force veteran.

Terminology related to financial documents in real estate can be intimidating. In this lesson, we will define some of the most common financial terms used in real estate and discuss how they impact the cost of borrowing.

Understanding Real Estate Financing

It costs money to borrow money. This is a simple concept, but there are some uncommon terms to the layman that come up regularly in real estate financing. Specifics of clauses and interest rates are not something that people think much about when they deal with a bank for regular things like checking accounts or debit cards, but financing real estate is a whole new ballgame. Let's go over several terms that may come up when dealing with real estate finance.

Interest Terms

How much is that home loan going to cost you? Here are a few terms that will help you understand just what lenders mean when they offer a loan at 4.2% APR with 1 prepaid point.

Interest is the cost of borrowing money. The interest rate is a percentage of the principal amount the borrower repays to the seller over a certain period.

APR stands for annual percentage rate. In real estate lending, this is an additional measure of the cost of financing beyond just using the interest rate. It includes other fees that are part of the loan, such as origination costs, mortgage points, and any other lender fees. Because of these extra fees, the APR will typically be higher than the interest rate. If the borrower makes payments as specified in the mortgage, the APR reflects the total cost of financing on an annual basis.

Points, also known as discount points, are a form of prepaid interest. One point costs 1% of the loan. A lender may offer a borrower points to discount the loan interest rate. Each point paid may typically reduce the interest rate by 1/2 to 1/4 of a percent. This also reduces the monthly payments. If the buyer holds the mortgage for longer than the time it takes to break even on the points compared to the interest rate, they can save money over the long run.

Clauses

Most mortgages these days include a number of clauses that set certain additional rules for the loan. These clauses are essentially 'if-then' statements. If the borrower does a specific act, then the consequence is clearly explained. Here are a few common ones to look out for.

Most loans contain a due-on-sale clause. This means that if the borrower sells the property or transfers ownership, then the lender can call the loan due and require immediate payment on the remaining balance. Lenders are not required to call the loan--this allows banks to prevent sellers from having the loan assumed by a new buyer. Banks tend to enforce the due-on-sale clause when they would rather make new loans as interest rates rise.

An escalation clause is a tool buyers can use when making an offer on a property. As with a regular purchase offer, the buyer offers a certain amount for the property. The clause specifies that if the seller gets a higher offer, the buyer will agree to automatically increase their offer to a certain higher price.

An acceleration clause requires the borrower to pay all or some of the remaining balance if specific conditions aren't met. Circumstances could be if the borrower misses a payment or breaks a certain term in the mortgage contract.

Other Useful Mortgage Terms

The following terms illustrate big picture concepts of the mortgage. How much is the buyer borrowing compared to the value of the property? How long is it going to take to pay the loan off, and how do the payments work? Are there any surprises or catches at the end of the term? Let's look at these concepts in a bit more detail.

The loan-to-value ratio is a ratio of the total mortgage amount compared to the appraised value of the house expressed as a percentage. If a borrower buys a house that runs $100,000 after closing costs and places a 25% down payment, the loan-to-value ratio is 75%. This value changes as the principal is paid down or as the house value appreciates or depreciates.

The term of loan refers to the set length of the mortgage. 30- and 15-year mortgages are standard loan terms. Before the term ends, the loan will have to be paid off or refinanced.

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