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Adjustable rate mortgage (ARM) |
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A mortgage in which the interest rate can change periodically, according to corresponding fluctuations in an index. See “Index”.
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Amortization |
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A portion of a loan payment is applied to pay the accruing interest on a loan, with the remainder being applied to the principal. Over time, the portion paid towards interest, and the amount applied to principal increases, eventually resulting in the pay-off of the loan (amortized) in the specified time. The amortization period of a 30-year fixed rate mortgage is thirty years.
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Annual percentage rate (APR) |
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Not to be confused with the interest rate, the APR is a value created according to a government formula intended to reflect the true annual cost of borrowing, expressed as a percentage. Because different loans have different terms (interest rate, points, fees, etc.) it is often difficult to compare them. The APR is a tool which takes these factors into account and allows for “apples-to-apples” comparisons to be made. Note that the APR is always higher than the actual interest rate on a loan.
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Appraised value |
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The fair market value of a given property, based on an appraiser's knowledge, experience, and analysis of the property. Lenders generally require that a property be appraised prior to providing funds to ensure that the property’s value is greater than or equal to the loan amount.
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Appreciation |
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The increase in the value of a property due to changes in market conditions, inflation, or other causes.
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Assessed value |
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Not to be confused with “appraised value”, the assessed value is the valuation placed on property by a public tax assessor for purposes of taxation.
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Balloon mortgage |
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A mortgage loan that requires that the remaining principal balance be paid in full at a specified time. A loan may be amortized as if it would be paid over a twenty year period, but requires that at the end of the tenth year the entire remaining balance be paid.
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Capital expense |
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Any scheduled “big ticket” expense associated with a property typically due to the expired “expected life” of a building material or system. An example of such might be replacing the roof, painting the exterior, replacing a furnace, etc.).
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Capitalization rate (cap rate) |
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A ratio between a property’s net annual operating income and the purchase price, the capitalization rate can be used two-fold. When shopping for investment properties, the cap rate provides great “apples-to-apples” property financial values for comparison. Conversely, when selling, the fair market value can be calculated by dividing the net annual operating income by the average cap rate for the area.
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Cash flow |
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Surplus cash generated from a given property after all expenses, debts, and tax obligations are discounted.
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Cash-on-cash return (COCR) |
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Profit expressed as a percent of initial actual dollars invested. For example, if a property’s annual post-tax cash flow is $4000 and the initial dollars invested was $22,500 (20% down on the $100,000 property plus $2500 in closing costs), the cash-on-cash return would be 4000/22,500 = .1778 = 17.78%.
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Closing costs |
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Closing costs are the fees associated with borrowing money such as appraisal fees, processing fees, underwriting fees, escrow fees, title insurance, points, and more. A lender estimates these items on the Good Faith Estimate which they must issue to the borrower within three days of receiving a home loan application.
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Cost of funds (COF) |
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Refers to the interest and non-interest cost of obtaining equity and debt funds. Closing costs are a portion of the cost of funds.
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Convertible ARM |
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An adjustable rate mortgage that allows the borrower to change the ARM to a fixed rate mortgage within a specific amount of time.
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Debt coverage ratio (DCR) |
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A ratio used by bankers to measure the safety factor between the income and debt service (net operating income/mortgage payment). The greater the DCR is over 1.00, the more comfortable the lender is likely to be.
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Depreciation |
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A decline in the value of property due to market conditions. Depreciation is also an accounting term which describes the loss of value of an asset over time, and therefore used as an expense to reduce taxable income.
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Discounted cash flow |
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An accounting method to value a financial asset using the concepts of the time value of money, or the future value of money in today’s terms.
For example, say you buy a house for $200,000. In five years you expect (hope) to sell the house fro $400,000. The obvious profit would be $200,000. If that profit is amortized over five years, the annual return would be about 14.9%. This may seem like a good return. However, since five years have gone by, the $200,000 profit is not worth the $200,000 that it is today – it must be discounted in terms of today’s money.
There are multiple discounts that can be considered: inflation, loss of opportunity (of other guaranteed investments), risk, etc. By applying an inflation rate of 3% per year that means that the $400,000 is really more like $351,000. Subtracting the purchase price by the discounted value gives $151,000 of discounted profit which equates to an annual return of 11.9%.
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Down payment |
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The part of the purchase price of a property that the buyer pays in cash and does not finance with a mortgage.
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Equity |
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A property owner’s financial interest in a property. Equity is the difference between the fair market value of the property and the amount still owed on its mortgage and other liens.
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Escrow |
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Money deposited with a third party to be delivered upon the fulfillment of a contract condition. For example, lending institutions often collect money into escrow every month for property taxes and homeowners insurance. This money is generally paid out to the appropriate parties twice a year on behalf of the property owner.
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Fair market rent (FMR) |
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A property’s rentable value as based on the average of similar properties in the same market.
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Fair market value (FMV) |
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A property’s saleable value based upon the average recent sale prices (not upon current listing prices) of similar properties in the same market.
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Fixed-rate mortgage |
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A mortgage in which the interest rate does not change during the entire term of the loan.
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Gross rent multiplier (GRM) |
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A ratio used to estimate the value of income properties. It is calculated by dividing the sale price of the property by its potential monthly gross income. For example, if the average GRM for a given market is 75 and a particular properties potential monthly gross income is $1600, the value of the property can be estimated to be 75 x $1600 = $120,000.
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Home inspection |
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A thorough inspection by a licensed professional that evaluates all the systems of a property. A satisfactory home inspection is often included as a contingency by the purchaser in the purchase agreement.
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Homeowner's insurance |
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An insurance policy that combines personal liability insurance and hazard insurance coverage for a dwelling and its contents.
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Interest |
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A fee paid on borrowed capital, the payment of which is generally amortized over many years.
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Internal rate of return (IRR) |
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The discounted rate of return of a given investment – see discounted cash flow for more information.
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Lease option |
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A financing option that allows a buyer to lease a property with an option to buy. Each month's rent payment may consist of not only the rent, but an additional amount which can be applied toward the down payment on a previously agreed upon price.
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Loan-to-value (LTV) |
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The percentage relationship between the amount of the loan and the appraised value or sales price (whichever is lower). Historically, lenders avoided LTV’s greater than 90% on residential properties and 80% on commercial properties, however, have allowed 100% plus LTV’s in recent years in some cases.
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Margin |
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The difference between the interest rate and the index on an adjustable rate mortgage. The margin remains stable over the life of the loan. The index (an hence the mortgage payment) can move up and down.
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Net operating income (NOI) |
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The difference between the gross operating income (potential income minus vacancy loss) and the operating expenses – things such as taxes, utilities, insurance, etc.
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Occupancy rate |
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The average percent of time that a property is rented over the course of a year. For example, units #1, #2, and #3 of a 3-unit investment property are occupied 12, 9, and 11 months in a given year, the occupancy rate = ((12/12) + (9/12) + (11/12)) / 3 = .8889 or 88.89%.
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Operating expenses |
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The on-going costs associated with an income producing property. Taxes, utilities, insurance, and legal fees are some examples.
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Principal, interest, taxes, and insurance (PITI) |
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The four components of a mortgage payment.
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Point |
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A point is one percent of the amount of the mortgage. Lenders charge points as a way to make an immediate profit, whereas buyers pay points in order to receive a lower interest rate.
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Prime rate |
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The interest rate that banks charge to their preferred customers. Changes in the prime rate are often used as the indexes in adjustable rate mortgages. Changes in the prime rate do not directly affect other types of mortgages, but the same factors that influence the prime rate also affect the interest rates of mortgage loans.
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Principal |
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The amount borrowed or currently unpaid. The principal is the portion of the monthly payment that reduces the remaining balance of a mortgage
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Private mortgage insurance (PMI or MI) |
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Mortgage insurance that is provided by a private mortgage insurance company to protect lenders against loss if a borrower defaults on the loan. Most lenders generally require MI for a loan with a loan-to-value (LTV) percentage in excess of 80 percent.
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Taxable income |
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The annual profit or loss that must be reported when filing federal and state taxes = (“Net Annual Operating Income” – “Annual Mortgage Interest” – “Depreciation of Building”).
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It’s a ratio between a property’s net operating income and mortgage payment. The greater the value over 1.00, the more comfortable the lending institution will be lending you money.
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It’s a ratio between a property’s net annual operating income and the purchase price.Look at it and understand it – it is very useful for comparing properties to one another.
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| It’s a ratio between a property’s annual pretax cash profit and down payment plus out of pocket closing costs. This is a very good indicator of what the investment yield of a particular property really is. |
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