FINANCIAL CALCULATORS - GENERAL HELP
Adjustable-rate mortgage
Adjustable rate mortgages
(ARMs) are mortgages whose interest rate fluctuates over time. Banks and
lenders adjust the interest rate periodically based upon the mortgage
agreement. Typical ARM-based loan agreements are comprised of an opening
or initial interest rate (sometimes also referred to as the “teaser
rate”), and restate the rate periodically, usually in 6 and 12-month
increments, known as the adjustment period, after some initial period. The
ARM’s interest rate is calculated by adding the loan’s adjustment margin
to the index rate. ARM’s usually have interest rate cap and lifetime cap
in place to protect the borrower from excessive increases in the interest
rate at any one time or over the life of the loan.
A sample ARM might offer the following:
“Opening rate = 3.5%; adjustment period = 6 months; index
rate = 3% (the current 11th District Cost of Funds Index (COFI)); an
adjustment margin of 3%; a rate cap of 1% each adjustment period; with a
lifetime cap of 12%.” Thus, the loan rate would start at 3.5%, but would reset
to 6% after six months, and would continue to adjust every six months
based upon the periodic increase/decrease in the COFI rate, with interest
rate changes not to exceed 1% in any adjustment period, and with the
interest rate never exceeding a maximum rate of 12%.
Adjustment period
The adjustment period is the frequency with which a lender
adjusts the interest rate of a variable-rate mortgage loan. For example, a
1-year ARM would have an adjustment period of one year.
Adjustment margin
The adjustment margin is the rate percentage that a lender
adds to the index rate of a variable-rate mortgage loan by to arrive at
the rate used for the mortgage. See Adjustable-rate mortgage for a
complete example.
Aggressive qualify estimate
When the economy is strong and the outlook is bullish,
financial institutions and mortgage lenders are more aggressive in their
lending due to the lower perceived risk of defaults. As a result, they
tend to lower their loan-qualification requirements to make it easier to
qualify for loan. See conservative qualify estimate for the contrasting
estimate.
Amortization
Amortization is the gradual reduction of loan principal
that occurs as the borrower makes monthly loan payments. Generally, the
loan principal is completely amortized with the final payment (except in
the case of loans with balloon payment options). As the borrower pays down
the loan each month, an increasing amount of each payment pays back the
principal, and a decreasing amount is computed as the interest charge.
Amortization also refers to the accounting process of spreading the cost
incurred upfront over the term of the loan or the life of the asset
purchased.
Amortization table
A table that itemizes the transactions in a mortgage or
loan repayment, generally listing the date of each payment, the amount of
each payment which represents principal and interest, based on the
interest rate and loan’s term, and the beginning and ending balances, per
period. This allows the borrower to determine how much money is still owed
to the lender at any point in time.
Anniversary date
Anniversary date is the periodic date, usually once a
year, of a loan, or for an adjustable-rate mortgage, the date that the
interest rate adjusts to its new level, based upon the adjustment period.
Annual percentage rate (APR)
APR represents the true interest rate that the borrower
pays to the lender, stated as a yearly percentage of the loan amount. It
is sometimes called the borrower’s effective borrowing rate. Closing costs
and discount points are added to the loan amount in order to calculate the
APR. For example, if the borrower is charged $1,000 in fees and closing
costs and it is added to the amount borrowed in order to secure a $9,000
loan, the APR will be higher than the stated interest rate because the
borrower is effectively only borrowing $9,000 but owes $10,000. The
Truth-in-Lending Act requires all lenders to disclose the APR to the
borrower (the fine print flashed on TV at the end of auto sales
commercials.)
Appraisal value
Appraisal value is the market value of an asset that is
determined from the appraisal process, which is usually required when
buying or selling a home or a used car. Depending on the asset (i.e.,
house vs. auto), the method used to appraise the asset will differ. For
homes, appraisers often use a method that includes recent sales data of
comparable homes. They may also use the replacement method, which is the
cost to replace the home at today's prices. For used automobiles, the
widely adopted standard is the Kelly Blue Book. For computer equipment the
Brown Index is becoming widely used.
Appreciation rate
Appreciation rate is the yearly percentage rate that an
asset increases in value. For example, assume you buy a house for
$200,000, one year later the home is worth $220,000 (10% more than when
you bought it), and two years later it is worth $242,000 (10% more than
the year before). Thus, the average annual appreciation rate is 10%
ARMs
See Adjustable Rate Mortgage.
Balloon payment
A balloon payment is a final payment the homeowner must
pay on their mortgage loan that is much larger than the monthly payments
the homeowner has made on the loan up until that time. The year in which
the balloon payment is made is called the balloon year. A balloon payment
occurs when a loan is amortized over a longer term than the loan rate. For
example, with a "5/30" balloon loan, although the loan’s payments are
computed using a 30 year term, a balloon payment is required at the end of
five years, and whatever amount is outstanding at that time is the final
payment (the un-amortized loan balance.) For example, if the homeowner
borrowed $100,000 at 6%, amortized over 30 years, the monthly loan payment
would be about $600 per month. However, if a balloon payment occurs after
five years (or 60 payments), the homeowner would owe $93,054.36 as a final
balloon payment needed to pay off the loan completely.
Base rate
Base rate is used as a benchmark used in order to set the
interest rate for borrowers. Base rate is also called the index rate.
Closing costs
Closing costs are the total costs the homebuyer or
borrower must pay to obtain the mortgage, usually at the “closing” and
upon acceptance of the borrower’s application by the lender. Closing costs
usually include application fees, underwriting fees, loan-origination
fees; mortgage points; title search and insurance fees; legal expenses;
escrow fees. For most residential mortgages, closing costs range from 2 to
7 percent of the amount borrowed, usually trending to the lower range for
a refinance mortgage versus a new home sale.
Conservative qualify estimate
When the economy is weak or the outlook is bearish,
financial institutions and mortgage lenders become more conservative in
their lending practices. As a result, lenders generally tighten their
loan-qualification requirements to make it more difficult for borrowers to
qualify for loans, thereby reducing their exposure to defaults. See
aggressive qualify estimate for the contrasting position.
Cost of Funds Index (COFI)
The San Francisco-based district office of the Federal
Home Loan Bank publishes a commonly used index rate for ARM loans, the
11th District Cost of Funds Index (COFI).
Cost-benefit analysis
Cost-benefit analysis is a common financial analysis that
compares the financial benefits of home ownership to the costs of home
ownership in order to determine the net cost. Included in costs are
mortgage interest, discount points, closing costs, property taxes and
homeowner's insurance, home maintenance costs, and any private mortgage
insurance (PMI). Included in benefits are the tax savings on deductions
for mortgage interest (including points) and property taxes, and an
increase in equity that the homeowner receives either from repayment of
the loan principal or an appreciation in the value of the homeowner’s
home. It is usually computed taking into account the time value of money.
Debt ratio
Lenders use a debt ratio (also called debt-to-income
ratio) to approve loan applicants. The debt ratio is arrived at by
combining all monthly debt payments and then dividing by the borrower’s
gross monthly income. For example, combined monthly debt payments of
$4,000 divided by gross monthly income of $8,000 equals a debt ratio of
50%.
Down payment
A down payment is the cash the borrower deposits towards
the purchase of a home, automobile, or other asset. The larger the down
payment, the less the borrower needs to borrow. For home loans, a down
payment of 20% of the home purchase price is generally required to avoid
private mortgage insurance. The value of a trade-in vehicle is often used
instead of a down payment for purchasing a vehicle.
Economic Growth and Tax Relief Reconciliation Act of 2001
(EGTRRA)
The Economic Growth and Tax Relief Reconciliation Act of
2001 (EGTRRA) introduced hundreds of new laws/rules into the tax code, but
most importantly it dropped the individual income tax rates for all levels
except the 15% rate, and set the lowest level at 10%. Tax rates for 2001
are 10%, 15%, 27.5%, 30.5%, 35.5%, and 39.1%. For 2002, rates drop to 27%,
30%, 35%, and 38.6%.
Equity
Equity is the borrower’s remaining ownership proportion of
a home's value after any and all debts against the property are settled.
Put another way, equity equals the fair market value of a home or other
asset owned by the borrower less any mortgage debt or other obligations
held against the home or asset.
Homeowner's insurance
Also called property insurance, homeowner's insurance
protects the homeowner from many forms of physical damage, as well as the
potential liability from accidents that happen on the property. Lenders
require homeowner's insurance coverage to secure their loan.
Housing ratio
Most financial institutions and mortgage companies use a
housing ratio to approve loan applicants. The Housing ratio is equal the
monthly mortgage payment divided by gross monthly income. For example, a
combined monthly mortgage payment of $1,500 divided by gross monthly
income of $4,500 equals a housing ratio of 33%. Generally, acceptable
housing ratios run between 25% and 40%.
Impounds
Impounds represent amounts that the borrower includes with
their monthly mortgage payment to ensure that the homeowner's insurance
premiums and real estate taxes are paid in full and on time. Sometimes the
borrower is required to deposit funds to cover these costs into an escrow
account at loan closing, and then the escrow agent pays the local tax
authority and insurer from this account.
Index rate
An index rate is a widely used interest rate that lenders
use to set the interest rate on loans and credit cards. For residential
mortgages, 10-year U.S. Treasury securities are often used for 30-year
fixed-rate loans. For ARM loans, a common index is the 11th District Cost
of Funds Index (COFI). For credit cards, the U.S. commercial prime rate is
frequently used as an index rate. For example, if the borrower obtains a
one-year adjustable-rate mortgage, the borrower’s loan rate will adjust
once a year to a rate that equals the loan rate plus a margin. Interest
rates on credit cards are frequently tied to a change in the prime rate,
another popular base rate used in consumer lending.
Initial interest rate
The initial interest rate (also called the opening
interest rate or the teaser rate) is the starting interest rate on an
adjustable-rate mortgage loan, which is often set at a rate lower than the
current ARM rates. The reason financial institutions set below market
initial rates is to both entice new buyers to these loans as well as to
assist buyers that may not otherwise qualify for a mortgage loan.
Interest-only mortgage payments
This type of mortgage payment is a loan that only requires
the borrower to pay the monthly interest and no principal. Because no
amount of the payment includes any principal repayment, no loan
amortization occurs and, thus, the homeowner does not accrue any equity
(unless the home value increases).
Interest rate
Interest rate is the cost of borrowing money or return on
investing money, usually expressed as a yearly percentage. Effective
interest rate, or Annual Percentage Rate (APR), is the true cost of
borrowing. It should include in the calculation those fees and/or points
the homeowner pays for a loan. As a result, the effective interest rate is
higher than simple interest rate. For investors or borrowers, the interest
rate is the rate earned on an investment or paid on a loan, usually
expressed as a yearly percentage. The simple interest rate is interest
paid or received divided by loan or deposit. For example, $10 in annual
interest on a $100 savings deposit represents a simple interest rate of
10% ($10/$100). More common, but more complex is a Compounded Interest
Rate, which is computed by finding the frequency of interest payments
during the loan or deposit period. For mortgages this is usually monthly.
For example, a 12% loan calculated as a simple interest rate would be 1%
per month, which, when compounded monthly equals an effective interest
rate of 12.68%.
Interest rate cap
A limit on the amount the interest rate can increase. A
periodic cap limits how much the rate can increase at each adjustment
period. A lifetime cap limits how much the rate can increase during the
term of the loan.
Lifetime cap
A lifetime cap is the limit to how much the interest rate
on an adjustable-rate loan can be increased over the term of the loan.
Loan-to-value (LTV) ratio
Loan-to-value ratio is a key factor in determining how
much of a home the borrower can qualify for. To calculate the
Loan-to-value ratio, divide the mortgage loan amount by the fair market of
the home value. A recent appraisal is generally required to determine fair
market value. If the borrower has existing mortgage debt or is adding
debt, divide the combined mortgage balance by the home value. For example,
a mortgage loan of $150,000 on a home that is appraised at $200,000 has an
LTV of 75%. As a general rule, mortgage loans that exceed an LTV of 80%
require private mortgage insurance.
Loan qualify estimates: aggressive versus conservative
Lenders ease their loan-underwriting guides when economic
times are good and outlook is bullish. This environment leads to more
competition among lenders for qualified borrowers. Thus, lenders become
more aggressive in making loans. When economic times are weak, lenders
become more conservative and tighten their lending requirements thereby
reducing the amounts they tend to lend.
Margin
Margin is the amount a lender adds to the base rate of an
adjustable-rate mortgage or other variable-rate loan to set the loan rate.
For example, if a one-year ARM loan has a margin of 300 basis points (3 %)
over the yield on 1-year Treasury bills and the T-bill yield is 6.5%, the
loan rate is set to 9.5%.
Marginal Tax Bracket
The marginal tax bracket is the tax rate that is applied
to the last dollar of taxable income the taxpayer earns. For example, if a
taxpayer owes $10,000 in tax on taxable income of $50,000, for an
effective tax rate of 20%, ($10,000 / $50,000), the same taxpayer may find
that they owe $11,000 in tax when their taxable income grows to $54,000.
Thus, the added $4,000 in taxable income was taxed at 25% ($1,000 increase
in taxable / $4,000 increase in income = 25%).
Mortgage points
Mortgage points are also called points, discount points,
loan discount points, loan origination fees or maximum loan charges. A
point is equal to 1 percent of the loan amount. For example, 1 point on a
loan of $150,000 equals $1,500. Lenders consider mortgage points as
interest that the borrower pays in advance. As a result, the more points
the borrower pays when the borrower closes the loan, the lower the
borrower’s interest rate charged on monthly payments. The borrower may be
able to deduct mortgage points in the year the borrower closes the loan
for tax purposes. Otherwise, the borrower will have to amortize the points
paid over the term of the loan.
Negative amortization
This is a phenomenon in home lending which occurs when a
payment cap restricts the repayment to an amount less than the payment
necessary to reduce the principal balance. This has the effect of
increasing the loan amount. Normally these types of loans are riskier and
more costly to the borrower and only used to allow a borrower to qualify
for a larger mortgage than otherwise possible.
Origination fee
The process of ‘funding the loan’ is usually called
origination. When the homeowner uses a mortgage broker (outside agent, not
affiliated with the financial institution) to assist in finding the best
mortgage, lenders sometimes charge an origination fee that is separate
from any mortgage points the homeowner must pay. These fees are usually
what the lender charges to cover the broker’s “commission” for bringing
the borrower and the lender together. Many brokers will negotiate these
fees with the lender beforehand to have their fees included as part of the
interest rate, so that they are not broken out as separate costs on the
escrow statement.
P + I
P+I is an acronym for loan Principal and Interest that the
borrower pays on an amortizing loan, including mortgage loans. If the
borrower’s mortgage loan payments include property Taxes and homeowner's
Insurance, the monthly payment amount is referred to as P+I+T+I.
P+ I + T + I
P+I+T+I is an acronym for loan Principal and Interest,
property taxes and homeowner's insurance.
Payment cap
Payment cap represents a limit on the amount that the
monthly payment can increase. A periodic cap limits the amount of the
increase at each adjustment period. A lifetime cap limits the amount that
the monthly payment can increase during the term of the loan. A potential
peril of payment caps is negative amortization. In the case of an
adjustable-rate mortgage with a payment cap, rising interest rates may
cause the loan payment to be insufficient to cover even the interest
portion of the scheduled payment. In this case, the unpaid interest may be
added to the mortgage loan principal, if the loan agreement permits.
Periodic rate cap
The periodic interest rate cap is the maximum amount the
loan rate can change on an adjustable-rate mortgage loan on the
anniversary date. ARM loan rates are often reset once a year after an
initial period. A lifetime cap often exists as well, which limits the
maximum loan rate that can be charged.
Points
Points are also called discount points, mortgage points,
loan discount points, loan origination fees, and/or maximum loan charges.
Financial institutions consider points to be interest that the borrower
pays up front when securing the loan. A point is equal to 1 percent of the
loan amount. For example, one point on a loan of $100,000 is $1,000.
Typically, the more points the homeowner pays up front, the lower the
interest rate the lender will offer. Subject to tax laws, the homeowner
usually can deduct mortgage points in the year they close the loan, but
not always. See a tax advisor to determine whether or not the points can
be deducted in the year the loan was issued, or whether to amortize the
points paid over the term of the loan, or not deduct them at all. This
analysis assumes the most common practice - Points can be deducted the
year the loan is issued.
Prepaid interest
Prepaid interest is the interest that the borrower pays
the lender in advance, often when the borrower closes on a loan in order
to allow payments to occur on the first of every month. If the borrower
closes a loan before the end of the month, the lender will require the
borrower to pay interest for the number of days until the end of the
month. This is one form of prepaid interest. Points that the borrower pays
at loan closing are recognized as prepaid interest and usually can be
deducted in the year the borrower closes the loan, but not always. See a
tax advisor to determine whether or not the points can be deducted in the
year the loan was issued, or whether to amortize the points paid over the
term of the loan, or not deduct them at all. This analysis assumes the
most common practice - Points can be deducted the year the loan is issued.
Present value
Present value is the value of a future payment, or series
of payments, discounted at the effective interest rate in order to compute
the value in today's dollars. For example, if a homeowner or investor
could choose between $100 today or a year from now, they would naturally
choose to take it now, since they can invest or spend it today for $100,
possibly earning them more money in that year. If the homeowner could
invest it at 10% simple interest, the homeowner would have $110 a year
from now ($110/$100).
Prime rate
Also known as the U.S. commercial prime lending rate, or
just prime, the prime rate is a commonly used index rate representing the
interest rate that major banks and financial institutions will charge to
lend funds to their most creditworthy customers. The prime rate is
frequently used as an index rate for credit cards.
Private mortgage insurance (PMI)
Private mortgage insurance is an insurance policy that a
residential mortgage lender requires of the borrower if the loan-to-value
(LTV) ratio of the home is greater than 80%. Mortgage insurance protects
the lender from the risk that the borrower may default on the loan.
Federal law requires lenders to notify borrowers when the loan-to-value
ratio drops below 80%, and it is usually a good practice to avoid PMI
whenever possible.
Property or Real Estate taxes
Property taxes are paid to the local taxing authority or
municipality, usually the county. The amount the homeowner pays are
typically tax-deductible. Property taxes are often charged as a percentage
of the home's assessed value. For example, if the homeowner pays 1% in
property taxes of the assessed value, a home assessed at $250,000 would
have a yearly property tax bill of $2,500. Property taxes are also called
real estate taxes. These taxes are paid to the local taxing authority or
municipality. The amount the borrower pays can generally be deducted from
the borrower’s federal income taxes.
Property or Homeowner’s insurance
Property insurance protects the homeowner from damage, as
well as potential liability from events that occur on the property.
Lenders require homeowner's insurance coverage to protect the asset, and
thus their loan. Some homeowner's insurance policies do not cover
catastrophic events such as tornadoes, hurricanes or floods. These kinds
of events generally require a separate insurance policy.
Refinancing
Refinancing refers to the process of paying off an
existing mortgage with the proceeds from a new mortgage. The new loan
typically has a lower interest rate, lower monthly payments, or other
aspects (i.e., switch from adjustable to fixed, removal of PMI, etc.) that
provide certain advantages (less uncertainty, more cash out, etc.) for the
borrower.
Savings interest rate
The savings interest rate is the yearly interest rate the
borrower earns on any savings invested, stated as a nominal rate before
taxes (usually expressed as APR).
Tax rates
The federal and state income tax rates are used to
calculate the impact of amounts saved or how tax-deductible items are
impacted, after tax effects are computed. For example, if a taxpayer’s
combined state and federal tax rates total 20% in 2001, and the interest
paid on the existing mortgage is $10,000 in that year (assuming it is
fully deductible for state and federal purposes), the marginal financial
impact is $8,000 ($10,000 less 20% in reduced taxes paid). Conversely, if
a loan refinance reduces interest paid by $2,000 in a given year, assuming
the same tax rates, the marginal financial savings opportunity is only
$1,600 ($2,000 less 20%, or $400 in higher taxes, since the interest
deduction is lower to the homeowner). See EGTRRA 2001 for more specific
information concerning interest rate change s in 2001 and 2002.
Tax savings or Tax shield
Tax savings or Tax shield are terms used to represent the
potential tax savings the taxpayer may receive from tax deductions or
credits that would otherwise be paid if the deduction or credit weren’t
available. To estimate the potential tax savings from a deduction,
multiply the deduction by the taxpayer’s marginal income tax rate. Thus,
the tax savings or shield available from $5,000 in home mortgage interest
would save as much as $1,000 in income taxes for a taxpayer with a
marginal tax rate of 20%, $1,500 for a taxpayer in a 30% marginal bracket
(remember to combine state and federal tax rates when computing the
marginal tax rate.), and so on. (Note: See the borrower’s tax advisor to
determine the tax deductibility of the borrower’s interest expense on
mortgage and home equity debt.)
Term
Term is used to define the length of time the loan remains
outstanding and payable, generally measured in years. Term generally
ranges between 15 and 30 years for Mortgage loans, although some
(undesirable) mortgages are computed over 40 years, but paid over 30. Auto
loans generally range between two and five years.
Time value of money
The economic and financial principal that a dollar saved
today will have far greater future value than a dollar received in future
periods, or in reverse, a dollar expected to be received in the future
will be worth less today since it requires less than one dollar saved
today for the future benefit. Factors such as the savings rate and
inflation are taken into account when determining the time value of money.
Underwriting
Underwriting is the process of evaluating a potential
borrower to see if they have the financial ability to repay the loan.
Yield
Yield measures the investment return of a bond and is
calculated in three major ways: current yield, yield-to-maturity and
yield-to-call. Current yield is the bond coupon rate divided by current
price. It is an expedient but incomplete method for calculating yield.
Yield-to-maturity (YTM) is the expected yield an investor earns for
holding a bond to maturity. YTM includes coupon income and any premium or
discount the investor pays. Yield-to-call is the expected yield an
investor earns if the bond is held until its first call date, when it is
assumed to be called by the company that issued the bonds. Difference in
bond yields is called the yield spread or credit spread. Yield spread
measures the extra yield a bond must pay to compensate for additional risk
over a risk-free bond. For example, if a 10-year corporate bond earns a
yield of 6.25% and a 10-year U.S. Treasury bond yields 5.75%, the yield
spread is 50 basis points.
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