Understanding Real Estate Loan Terms

by : Kris Koonar

When people buy property for the purpose of investment, they may either invest their own spare money or may opt for an investment loan from an institutional lender. There are many factors that should be considered before deciding on the right type of loan.

The first thing to consider is the rate of interest. This is crucial because the rate of interest has a material bearing on the installments to be paid each month and the actual price that you can afford to pay for the property. Since installments are regular monthly payments they would affect the cash flow, and depending on your financial obligations, have an effect on your decision to hold or sell off the property.

Loans can be structured in different ways. They can be simple interest loans or they can be amortized. In a loan based on simple interest, calculations are easy, with the loan amount multiplied by the interest. For example, a loan for $200,000 at an annual interest rate of twelve percent would require yearly interest payment of $24000, which would be $2000 every month. Here the payable amount is only the interest and there is no reduction in the principal amount.

Loans that are amortized are very different and need to be calculated in a way that is rather complex. In an amortized loan, the principal amount of the loan is equally divided by the number of months for which the loan has been obtained giving an equal monthly payment with respect to the principal. However, the payment of interest is calculated each month on the outstanding amount of the principal. So the actual cumulative amount payable against principal and interest would be different for each month. In an amortized loan, as you go on making payment of installments, the principal amount of your loan continues to get reduced.

Then there are balloon mortgages that require the full amount of the loan to be paid after a particular period of time. For example, a 5 year interest only loan could require payment of interest for five years after which the full principal amount would be payable in one lump sum or it may result in foreclosure. Then again, in an amortized loan for thirty years, the principal balance may be due in five years. Not paying the amount may result in foreclosure.

The financial markets are fraught with uncertainty. It makes future interest rates very uncertain. This uncertainty has made many lenders offer variable rate financing which is also known as adjustable rate mortgage or ARM. These mortgages are structured to offer many alternatives to suit the lenders business requirements and the needs of the borrower. One of the salient features of the ARM is the cap on increase in the interest rate on the loan. These caps are of two types. One limits the increase up to a certain percentage till the life of the loan and the other limits how much it can be increased at one time.

For example, the final cap on a loan given on 8 % may be 13% till the life of the loan but the amount of increase in the rate cannot be more than 2% at one time. The adjustments for the increase are made periodically which may be every month, six months, yearly or every few years. The benchmark for determination of the increase is an outside index on which the ARM is based. It may be the London Interbank Offered Rate or LIBOR or Cost of Fund Index (COFI).