Mortgage and Loan Definitions
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LOAN AND DEBT
ARM – Adjustable Rate Mortgage
An adjustable rate mortgage has, as the name suggests, a variable interest
rate. At the beginning of the term the interest rate is lower, causing the
borrower's house payment to be lower as well. This makes ARMs popular
with borrowers beginning careers and confident of increasing income in the
future, or in relatively short term housing situations. ARMs adjust their
interest rates based upon an index. Common ARM indices are the London
Interbank Offered Rate (LIBOR), 12 month Treasury Average Index (MTA),
11th District Cost of Funds Index (COFI), and the Constant Maturity Treasure
ARMs are usually stated with the number of years for the initial period, where
the “teaser” interest rate applies, followed by the adjustment period.
Examples of this include 3/1, 5/1, and 7/1. These terms indicate, in the case
of a 3/1, that the mortgage interest rate will be the initial rate for the first 3
years, then will adjust every year there after. On most ARMs this adjustment
is limited by a cap to avoid the rate spiraling out of control. The caps are
usually incremental and total. These limit how much the interest rate can
adjust at each interval and in total throughout the period of the loan.
Debt Consolidation Loan -
This is a loan that is used to consolidate a number of loans into a single
financial obligation. Typically these loans are used to retire a number of
credit cards. Since credit cards tend to have relatively high interest rates the
monthly payment of the debt consolidation loan is lower than the total
payments for the retired credit card debt. In most cases the consolidation
loan has a lower interest rate because it is a secured loan, and so
represents a lower risk for the lender. The lower risk translates into a lower
interest rate for the borrower.
On the positive side, a debt consolidation loan will usually improve the
borrower's monthly cash flow situation, allowing them to consolidate not only
their credit card debt, but also their financial position. On the negative side,
since most of these loans are secured by the borrower's home, a default on
the loan will mean the borrower loses the home. Putting a home at risk is no
small decision, and should not be taken lightly. Another minus to debt
consolidation loans is that, due to their longer term, typically 10 – 30 years,
the total interest payments made for one of them could actually be much high
than for the credit cards they replaced, even though the monthly payments
are much lower.
HELOC – Home Equity Line of Credit
This is a line of credit that is secured by equity in your home. As with any line
of credit the borrower has the ability to draw money from the credit line up to
the lines maximum, and repay it at agreed upon terms, similar to a credit
card. Rates for home equity lines of credit are typically much more favorable
that rates for most other credit lines however. Unlike a home equity loan, the
borrower is not required to withdraw the entire amount of the credit line. The
borrower is thus not liable for repayment of the entire amount, only the
amount of credit they actually use, plus accrued interest on the outstanding
Refinance – A refinance loan is a loan that is used to pay off an existing
loan, typically with more advantageous terms for the borrower. These are
most common with mortgages and student loans, although they are widely
used for car loans and personal loans as well. One type of refinance that has
been extremely popular as real estate values have appreciated is the cash
out refinance. With a cash out refinance, the borrower takes advantage of a
home's appreciation since it was originally financed. The appreciation
creates equity in the home, and this equity is borrowed against when the
home is refinanced.
As an example, say a home was originally purchased for $125,000. The
home now appraises for $250,000, leaving the homeowner with $125,000 of
home equity. When they do a cash out refinance, they borrow some or all of
the $125,000 in equity, in addition to enough to pay off their original
mortgage. This cash may be used for anything the borrower sees fit, such as
retiring high interest credit card debt, a down payment on investment
property, or improvements to their existing home.
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