Are you looking to get involved in real estate but aren’t quite sure what some of the key terms mean?
This is a common sentiment shared by many real estate beginners. Lots of terms are thrown around that you may not necessarily understand, whether that’s because you haven’t heard them before or because they’re being used in a novel context. There are an abundance of real estate terms that beginners must be familiar with, although the most commonly misunderstood are related to real estate finance. Understanding the language your real estate agent or lender is using is key to being savvy and successful in the long term. This will ensure that you are well informed and capable of making the best decisions with your money.
Loans: Principal vs. Interest
Simply put, this is the amount of money you borrow from the lender that you must pay back. It is important to note that this does not include interest. The total value does not change, because it is the original sum you borrowed. Typically, your mortgage payment statements will include a breakdown of exactly how much of your payment goes toward the principal of your loan. Some lenders will even allow you to make principal-only payments in addition to your total monthly payment. By taking advantage of these additional payments, you can significantly reduce the term and total cost of borrowed funds, including that of a mortgage loan.
Interest is distinct from the principal because it is an accrued cost that is in addition to the amount of money you originally borrowed. This can be thought of as the cost of borrowing the principal. This interest accrues over time depending on the remaining principal of the loan. That’s why paying down the principal as quickly as possible has such a significant impact on the total cost of the loan. This will vary depending on the life of the loan and the monthly payment amount, and it is determined by the annual percentage rate (APR), which is a percentage of the principal. Together, principal and interest make up the total balance of your loan.
So how do I pay off both principal and interest?
The simple answer is amortization. This accounts for both the principal and interest payments, and it is how you are going to pay off a loan. While your monthly payment amount remains the same, the percentage of that monthly payment that goes towards paying off interest versus principal will change. At the start, the majority of your monthly payment will go towards paying off interest. But towards the end of the loan term, the opposite will be true and you will be paying more towards principal than interest. An amortization table, which shows you the breakdown of your monthly payment and how much of a balance you still owe, can be useful in understanding where your money is going and how much of your principal remains outstanding.
There are a few different definitions of equity, but as it relates to real estate, equity is the component of a property you actually own. So, as you pay off your mortgages or other debts on a given property, your equity in it increases. To make it more clear, consider this fundamental equation (which should definitely be committed to memory):
Equity = Assets - Liabilities
In the case of property ownership, think of it like this: equity = assets (the property) - liabilities (mortgages or other debts on the property). Thus, the smaller the liabilities portion of that equation, the greater the equity portion. The fact that there are two primary contributors to this equation means that you can substantially increase the equity in your home by either increasing the value of the property or paying off your loan. Equity is critical because it contributes to your net worth, which, when higher, gives you greater financial leverage. Thus, improving the value of the property, whether through organic appreciation or through work done to the property, and paying off as many debts as you can increases your equity and, in turn, your financial power.
Finances hardly ever stay in one place. Sometimes your financial situation will change, or better options will become available to you after your initial loan. If this is the case, you can refinance the loan, or replace the existing loan with a new one that improves your finances in some way while still paying off the remaining debt you owe. However, it can: lower interest rates, alter the loan term, lower monthly payments, or consolidate debts (ex: multiple loans). Refinancing is something worth considering, but it isn’t for everybody. Understanding what options are out there is important. Who knows, maybe you can strike a better deal!
Debt-to-Income (DTI) Ratio
The DTI ratio is a metric which shows one’s debt and income balance. It is calculated by comparing your total monthly debt payments and your gross income, or income before accounting for taxes or other deductions. The formula is as follows:
DTI = Total Monthly Debt Payments / Gross Monthly Income
The lower this percentage, the more appealing you are to a lender, because it means less of your gross income is going towards paying off debts. In other words, you are more profitable. Typically, 43% is the highest DTI ratio that lenders permit for a mortgage, but below 36% is preferred. However, it is important to note that there are limitations to this calculation. Since debts are lumped together, the DTI does not distinguish between various types of debts. If you switched to a credit card with lower interest rates, for example, your DTI ratio would decrease, despite your total amount of debt being unchanged. Here is a quick example:
Alice’s monthly bills and income are as follows:
- Mortgage: $2,000
- Credit cards: $500
- Auto loan: $1,000
- Boat loan: $1,000
- Gross income: $10,000
Alice’s total monthly debt payment is: $2,000 + $500 + $1,000 + $1,000 = $4,500.
Alice’s DTI is $4,500 / $10,000 = 0.45 = 45% (remember the formula!).
Alice would have a hard time getting another mortgage with a DTI of 45%!
These are just a small sample of the many terms relevant to real estate financing, but they are some of the most crucial for beginners to understand. We hope that this has been helpful in making real estate more familiar, bringing you one step closer to your real estate goals.