“I like surprises. But only on my birthday.”
I have said that line to my clients more times than I can remember during the past 10 years of my mortgage lending career. When possible and appropriate, I would always review the initial loan estimates and key terms with my clients either in person or by phone/email.
I get it.
When it comes to real estate transactions and big financial commitments, nobody likes the kinds of surprises that can cost you time, money, and stress.
For that reason, I’ve provided the basic financing terms you need to learn when considering a private money loan for your purchase or refinance. Initially, this post was titled the “9 Basic Terms”, but I felt compelled to switch it to the “9 Critical Terms”. These are basics, but also vital conditions to the formal loan contract that you will commit to.
So here is the list of the 9 Critical financing terms you should learn, along with my Plain English definitions of what they mean. Please also visit our Real Estate Glossary for a full listing of real estate terms.
1. Interest Rate
The percentage of a sum of money that a lender charges for its use. This is the charge that you pay the lender for the use of the money. The interest rate is expressed as a percentage per month or year of the loan amount borrowed. (Such as 10% Interest)
2. Loan-To-Value Ratio (LTV)
The relationship, expressed in a percentage, between the loan amount and the appraised value (or purchase price) of the property. For example, a loan amount of $65,000 secured against a property valued at $100,000 would give you a 65% LTV. In other words, you are putting a debt against the property for 65% of the current property value. By comparison, the remaining equity in the property would be $35,000 or 35%.
If the loan amount is $50,000 and the property value is $100,000, you then have a 50% LTV.
3. Loan Term
The term of a loan is the length of time that the loan is written for. This can be represented in months or years. A 30-year fixed rate mortgage would have a loan term of 360 months (30 years). It is common to find private money loans with terms ranging between 3-7 years, or 36 months- 84 months.
4. Maturity Date
The date by which a loan is to be paid in full. In other words, the date by when you need to pay the full balance back. Think of it as the Due Date.
5. Balloon Payment
Here is the definition by the Department of Real Estate: An installment payment on a promissory note – usually the final one for discharging the debt – which is significantly larger than the other installment payments provided under the terms of the promissory note.
Plain English: Your final big payment to pay off the entire loan balance in full. For example, if you are at your maturity date and you still have an outstanding balance, you would need to make one big payment to pay the loan off to a zero balance.
Supposing you still owe $100,000 on your loan, your final balloon payment would be $100,000.
6. Amortized payments vs. Interest Only Payments
Amortized payments include Principal and Interest, which is how 30-year fixed rate mortgages work. The loan term is for 30 years, and the payments are scheduled so that you will pay off your mortgage after 360 on-time payments (30 years). This means that your loan is amortized, or that your loan balance is paid down with every payment.
Interest Only payments only cover the accrued interest due. No principal payment is collected in Interest Only payments.
If you have a $75,000 loan amount and you only make Interest Only payments for a year, you would still owe the full $75,000 because your monthly payments did not reduce any principal.
It is up to you to make the necessary principal payments when you can. Since private money loans are short-term loans, most borrowers only make Interest Only payments because they will be paying off the entire loan soon. It further helps both the borrower and lender to keep “round numbers” for the pay-off of the loan.
7. Fixed Rates vs. Adjustable (Variable) Rates
There are 2 types of interest rates: Fixed and Adjustable.
A fixed rate has the same Interest for the life of the loan.
If the interest rate is not fixed for the entire length of the loan, it is by default considered adjustable. For private money loans, you will normally only see fixed rates.
8. Prepayment Penalties
The charge payable to a lender by a borrower under the terms of the loan agreement if the borrower pays off the outstanding principal balance of the loan prior to its maturity.
Okay, that was a mouthful.
If your Promissory Note (loan agreement or contract) contains a pre-payment penalty, you will be charged an additional fee if you pay off the entire loan before the due date.
Prepayment penalties are not as common these days, but make sure you ask if the loan you are being offered has a prepayment penalty or not.
9. Guaranteed Interest requirements
A Guaranteed Interest clause in a loan agreement “guarantees” that the investor (lender) will receive a predetermined amount of interest back on the loan they give to you.
This is similar to a pre-payment penalty, but not exactly. Here’s an example.
If your private money loan has a 6-Month Guaranteed Interest condition as part of the loan terms, it means that you will agree to one of two things: either make a minimum of six monthly payments as scheduled or pay the remaining months of interest if you should happen to pay the loan off before the six months is up.
If you take out a private money loan in January, and you pay the loan off in April, you would pay the full loan amount due plus 2 additional months of interest for May and June.
This clause is a common feature found in private money loans so that the investor ensures they make back at least 6 months of interest for making the loan. (To make it worth their while)
Want to learn more? The links below will help you save you time, money, and stress…
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