The mortgage business has a large body of jargon that sometimes does not match the definitions that a layman might assume. Some key words, such as “subprime”, have very vague definitions that come down to: “you know it if you see it.” Here are some key terms and their definitions.
Subprime: lending that involves elevated credit risk. To assess credit risk, lenders take into account a borrower’s credit history (FICO score), mortgage characteristics (such as LTV) and attributes of the property. Generally a FICO score below 620 is considered to signify elevated credit risk.
FICO score: represents a borrower’s credit history. FICO scale is from 350-850.
Loan-to-value (LTV): loan amount expressed as a percentage of property value.
Agency loans: issued by US government-sponsored enterprise (GSE), such as Fannie Mae, Freddie Mac, and Sallie Mae. They are backed by the government, but not guaranteed since GSEs are private entities. Having stricter underwritten guidelines, they generally exclude exotic/risky mortgages.
Jumbo: a loan that exceeds the size limit for securitization by GSEs (currently: $417,000)
Alt-A: usually a strong FICO score, but little documentation of income or assets. It is designed for self-employed and other individuals who are willing to pay a premium to avoid verifying their income.
Alt-B: Alt-A requirements with lower credit score; the lowest sector of the prime market.
Adjustable rate mortgage (ARM): Interest rate is periodically adjusted based on an index (i.e. TSY bill, prime rate, libor). Change in monthly payment amount is usually subject to a Cap (limit).
Hybrid ARM: Rate is fixed for a period of time and then floats thereafter. Initial fixed rate is a discounted “teaser” rate. For example, a 2/28 has a fixed teaser rate for the first two years and an adjustable or fixed rate and amortize the principle over the remaining term of the loan.
Interest-only ARM (IO): borrowers make only interest payment for a fixed period at either an adjustable or fixed rate and amortized the principal over the remaining term of the loan.
NegAm ARM (negative amortization): borrower pays back less then the full amount of the interest owed each month. The short amount is added to the loan balance so the principal increases over time. Most NegaAm are allowed for only five years and have terms to “recast” payment to fully amortizing schedule if borrower allows principal to reach a pre-specified amount (usually 115% of originally loan amount)
Option ARM: allowed to make minimum payment (similar to credit cards) or larger amounts at borrowers’ discretion.
Prepayment penalties: extra fees due if the borrower pays off the loan early by refinancing or selling the home, usually limited to the first 3-5 years of the loan’s term. They are included in the majority of ARM contracts.
Foreclosure: legal process by which the property is sold to satisfy the debt. There are two main types: judicial (court action) and power-of-sale (non-judicial, settled by appointed trustee outside of court). Process varies by state.
REO: real estate owned. The implied subject is the lender. In most cases, foreclosure ends with lender owing the property. The lender eventually sells the property (REO disposition), recovering some portion of the loan.