Loan Terms to Pay Extra Attention To

When you talk to a loan officer about getting a mortgage, the loan programs that you will be offered will contain certain conditions or promises on the part of the borrower and the lender. These are called the “terms” of the loan. Note that that there are two different definitions of the word “term.” “Loan terms” means the conditions of the loan, but the “loan term” (singular) means the duration of the loan.

Here are some common loan terms that you should watch out for:

Loan term vs. amortization time

To “amortize” a loan (from Middle French “amortir” which means “to bring to death”) means paying off a loan in payments over time to the point where no more money is owed. The debt has gone down to zero. The amortization time is the time theoretically required to pay off the debt by making regular scheduled, predefined payments. Most people would expect that the loan term, the duration of the loan, is the same as the amortization time—but this is not always the case.

Balloon payment

For example, in some loan contracts, the lender agrees to a loan amount and schedule of payments that would mathematically enable the borrower to pay off the loan over a period of 40 years. But they also specify a loan term of 15 years. This means that the loan agreement comes to and end in 15 years, at which time the lender will expect the loan to be fully repaid. In this scenario, the borrower will owe the lender the remaining loan amount at the end of the loan term (15 years), because the borrower has been making payments that will mathematically pay off the loan in 40 years. This is known as a “balloon payment” (a large payment owed at the end of a mortgage term). In this scenario, the balloon payment could be over half of the original loan amount. The borrower may suddenly find himself owing $500,000 and receive a notice that he has 30 days to pay it. If he is not able to pay it, his house may be repossessed by the lender.

This is something borrowers should watch out for. It could not only happen with a purchase, but also with a refinance or “loan modification.” A loan modification occurs when a borrower is unable to make payments and a lender agrees to modify some of the terms (conditions) of the existing loan agreement, such as allowing the borrower to make a lower monthly payment but extend the term (length) of the loan. You have to be very careful with this, as this option is often not in your best interest. You may end up paying more interest over a longer period of time, or, if the monthly payments are lowered but the loan term if not extended, you may suddenly end up owing a balloon payment.

This may not appear to make sense, but many loan modifications contain such terms. There are some situations in which this arrangement does make sense for the borrower—if you would like to find out about this, please contact us for a free consultation.

Before signing any loan contract, you should always get help from a qualified professional who can read and understand the entire loan contract and will explain to you how different terms will impact you in the short and long run.

Adjustable rate mortgage (ARM) & “Hybrid” ARM

An adjustable-rate mortgage (also known as an ARM) is a mortgage with a fluctuating interest rate. The interest rate can change over time—in step with changes to a basic interest rate that is set for banks in the entire United States by the Federal Reserve. A committee within the Federal Reserve meets and votes on this basic interest rate (called the “federal funds rate”) about once every seven weeks.

Because the rate of an adjustable-rate mortgage can increase significantly over time, it is risky for borrowers. Because of the risk involved, ARM rates are usually cheaper than fixed-rate mortgages. ARMs do fulfill a function in real estate, and they are not always a bad idea. If you are a real estate investor and/or plan to resell your property within a short period of time, an ARM may be an option for you. However, if you plan on keeping your property for many years, then an ARM may not be a good idea.

An especially tricky version of the adjustable-rate mortgage is the “Hybrid ARM.” A “hybrid” is something of mixed composition, and a “Hybrid ARM” is a mortgage that starts out as a fixed-rate mortgage for a specified amount of time and then turns into an adjustable-rate mortgage. For example, you could have a mortgage with a fixed interest rate for five years. After that your interest rate would adjust according to changes made to the basic interest rate (the “federal funds rate”) as determined by the Federal Reserve. This catches a lot of borrowers by surprise, as they either forget or did not anticipate that interest rates could skyrocket as much as they did in a period of just a few years.

Make sure you know what you are signing

Advising people on mortgages is a real skill that should be done by a trained financial professional. It involves competence in many fields, including being able to read and understand lengthy loan contracts, understanding how different loan terms and rates will impact a borrowers finances and ability to pay over the long term, and talking to borrowers with patience, understanding their financial situations and goals, and giving them access to mortgage programs that are suitable for their needs.

Make sure that your loan officer explains all parts of your mortgage contract, and ask for clarification if you are not sure that you understand something. Mortgage contracts are no joke—they are a legally binding document that you will be held to by the lender in the future. As most mortgages are quickly resold to another institution after they are made, you will likely not even be dealing with the same lender as the years go by. So it is important to have good agreements in writing—agreements that are suitable for your situation and that will be beneficial to your finances for years to come.

What to do if you are not happy with your current mortgage

If you are not happy with your mortgage, you may be able to get out of it by doing a refinance. When you do a refinance, you get a new mortgage from a different lender with different terms (conditions), and you use it to pay off your old mortgage. You then continue making payments to your new mortgage.

If your property is located in California and you would like a second opinion on your existing mortgage contract, please call us for a free consultation. We will listen to your situation, answer all your questions and let you know what your options are, including if you are likely to qualify for a potential refinance.

Call us at 310-294-9417 for a free consultation.

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— Kristina, Client