Today is vocabulary day. The financial world has its own language, and many of those terms can be very confusing. So let’s take a look at some frequently-used terms that could be very important to you.
1. Adjustable Rate Mortgage (ARM)
ARMs are home loans with interest rates that are reset periodically. These mortgages usually have an introductory period with a fixed interest rate. Once that rate expires, the interest rate will be reset periodically. The introductory, fixed-rate period could last three, five, seven, even ten years, before switching to an annual adjustment schedule.
2. Compound Interest
Interest that is added to the principal at set intervals. In terms of savings, the more often interest is compounded, the better. That’s because once the interest has been added to the principal, you begin earning interest on that sum – you’re earning interest on interest. Compound interest on credit cards, on the other hand, can make your debt balloon quickly.
3. Debt-to-Income Ratio
The comparison between what you owe and what you earn. It’s one of the factors that will influence your credit rating, and that lenders look at when deciding if or how much to lend you. Banks will be hesitant to lend to you if this ratio is too high, and really, you should be wary of borrowing more money if you have a high debt-to-income ratio. You might be on your way to borrowing more than you can afford to repay.
This term refers to the status of a loan that a borrower has not repaid according to the agreed-upon conditions. Typically, it means that the borrower hasn’t been making their loan payments, and it’s a very serious problem. Defaults will leave black marks on your credit history for years, making it harder and more expensive to get future loans. Defaults on mortgages occur prior to foreclosure.
When a homeowner defaults on a mortgage, the bank takes possession of the property in question through a legal procedure called foreclosure. Banks usually sell foreclosed properties to recoup some of the money owed on the property.
6. Index and Spread
An index is a number that banks use to determine variable interest rates. For example, the Wall Street journal publishes the Prime rate, a variable index on which interest rates may be based. The spread is a percentage that is added to the index to determine the interest rate. Your interest rate on a loan may be Prime + 2.5%, and will change at set intervals based on the current Prime rate.
Principal is the loan amount borrowed, and does not include interest. Interest is based on a percentage of the principal. Many mortgages and other loans let you make additional payments against the principal, which helps you pay off your loan quicker.