Financing basics: note, deed of trust, LTV, PMI, points, interest, PITI, underwriting

Bottom line: most buyers need a loan. Knowing the two loan papers, the main ratios, and the monthly math lets you explain a deal in plain words, though only a licensed lender or loan originator may give loan advice.

Two documents, two jobs

A promissory note is the borrower's written promise to repay a stated amount with interest on stated terms. It is the debt. A security instrument is the paper that pledges the property as security for the debt. In many states it is a mortgage. Colorado uses a deed of trust.

A deed of trust has three parties: the borrower (trustor), the lender (beneficiary), and a neutral trustee who holds legal title as security. In Colorado the trustee is the county public trustee, a county official who handles foreclosures and releases. If the borrower defaults, the lender starts a foreclosure through the public trustee, who runs the sale (C.R.S. 38-38-100.3 and following; see the notice rules in 38-38-103 and the right to cure for nonpayment in 38-38-104). When the loan is paid off, the lender asks the public trustee to release the deed of trust. The deed of trust is recorded in the county records so the public knows the lien exists and its date (C.R.S. 38-35-109).

The key numbers

• Down payment: the cash the buyer puts in. Price minus down payment = loan amount.
• Loan-to-value (LTV): loan / the lower of price or appraised value. Lower is safer for the lender.
• PMI (private mortgage insurance): on conventional loans with less than 20% down, the buyer pays insurance that protects the lender, not the buyer. Under the federal Homeowners Protection Act, the borrower can ask to cancel when the balance reaches 80% of the original value (given good payment history), and it ends automatically at 78%. FHA loans use a different system called MIP.
• Interest: the cost of borrowing, set as a yearly percent. In early years of a 30-year loan most of each payment is interest. This is amortization: paying off the loan over time with level payments.
• Points (discount points): prepaid interest. 1 point = 1% of the loan amount. Paying points buys a lower rate.
• Origination fee: what the lender charges to make the loan, often quoted as a percent of the loan.
• PITI: Principal, Interest, Taxes, Insurance, the full monthly housing payment. Taxes and insurance are usually collected by the lender into an escrow account and paid when due. HOA dues are separate but are counted by lenders.
• Debt-to-income ratio (DTI): monthly debts / gross monthly income. The front-end version counts only housing; the back-end counts all debts (car loan, student loan, cards).

Underwriting

Underwriting is the lender's review of whether to approve the loan. They study the "four C's": credit (the score and history), capacity (income and DTI), capital (down payment and savings), and collateral (the house, checked by the appraisal). Brokers should never promise a buyer will be approved.

Federal law requires lenders to give standard loan cost disclosures (TILA and RESPA). A broker should not take a kickback for referring a buyer to a lender; RESPA forbids it.

Loan clauses to know

• Acceleration clause: lets the lender demand the whole balance at once if the borrower defaults.
• Due-on-sale clause: the lender can demand full payment if the owner sells or transfers the property. This is why most existing loans cannot just be "taken over" without lender approval (federal law supports these clauses: Garn-St Germain Act).
• Prepayment penalty clause: a fee if the loan is paid off early. Many modern home loans have none. Check the note.
• Escrow / impound clause: the lender collects taxes and insurance monthly.

Common loan types: conventional (no government backing), FHA (insured by the Federal Housing Administration, lower down payments), VA (for eligible veterans, often no down payment), and USDA (rural areas).

Example with real numbers

A buyer buys a Boulder County house for $500,000 with 20% down: $500,000 x 0.20 = $100,000 down. Loan = $500,000 - $100,000 = $400,000. LTV = $400,000 / $500,000 = 80%, so no PMI.

The rate is 6.5% for 30 years (360 months). The monthly rate is 6.5% / 12 = 0.5417%. The standard payment formula gives principal and interest of $2,528.27 a month. Check the first month: interest = $400,000 x 0.065 / 12 = $2,166.67, so only $2,528.27 - $2,166.67 = $361.60 reduces the loan.

Add taxes of $4,200 a year ($350/month) and insurance of $1,800 a year ($150/month): PITI = $2,528.27 + $350 + $150 = $3,028.27 a month. With gross income of $9,500 a month, front-end DTI = $3,028.27 / $9,500 = about 31.9%. Add a $400 car payment: ($3,028.27 + $400) / $9,500 = about 36.1% back-end.

Over 30 years the borrower pays $2,528.27 x 360 = about $910,178. Subtract the $400,000 borrowed and interest alone is about $510,178.

Points: 1 point on this loan = 1% x $400,000 = $4,000. If it drops the rate to 6.25%, the payment falls to $2,462.87, a saving of $65.40 a month. Break-even = $4,000 / $65.40 = about 61 months (about 5 years). The buyer only wins if they keep the loan longer.

Less down: with 5% down the loan is $475,000, LTV 95%. If PMI costs 0.5% a year, that is $475,000 x 0.005 = $2,375 a year, about $198 a month, until the balance reaches 80% (then it can be canceled on request).