Buying a home might be the largest single financial investment you ever make. Due to the hefty price tag, you will likely need a mortgage. The interest rate charged on the loan ultimately determines the cost of the mortgage and the size of your monthly payments. Even a small difference in rates greatly affects how much interest you'll pay over the life of the loan. Take a $250,000 30-year fixed-rate mortgage, for example: At 4.5%, your monthly payment would be $1266.71, and you'd end up paying a total of $206,016 in interest (assuming you stick to the amortization schedule). At 4%, your monthly payment would drop to $1193.54, and you'd pay $179,674 in interest or $26,342 less than the 4.5% loan.
Because the mortgage rate makes a big difference in how much you'll pay for your home, it makes financial sense to shop around for the lowest rate you can qualify for. Here are the five steps to take.
1. Get Your Credit Score.
Lenders will use your credit score to help determine if you qualify for a loan and what rate you'll be charged. In general, the higher your credit score, the better the mortgage you'll be offered. It's a good idea to get a copy of your credit report at least six months before you plan on shopping for a mortgage so you have time to find and fix any errors (your own credit inquiry should not count against your credit score).
Once you start shopping, each lender you contact will want to pull your report. While you may have heard that it will lower your credit rating each time a lender makes a credit inquiry, you can limit any dings to your credit by doing your shopping within a focused period. Credit agencies recognize that shopping for a mortgage results in a single loan (and not multiple new lines of credit). The FICO Score, for example, disregards multiple inquiries when they happen within a 45-day window; other agencies have a 14-45 day window.
2. Consider Mortgage Types.
Before you shop, determine how much you want to borrow, which type of mortgage you want and how long a term you need so that you can fairly compare lenders. Three basic mortgage types include:
- Fixed-rate mortgage. A fixed-rate (or "plain vanilla") mortgage is a conventional loan that has a set (or fixed) rate of interest for the entire loan term, allowing you to spread out the costs of your home purchase over time while making predictable payments each month. Fixed-rate loans are ideal for buyers who have steady sources of predictable income and who intend to own their homes for extended periods of time.
- Adjustable-rate mortgage (ARM). An adjustable-rate mortgage (also called variable-rate or floating-rate) is a conventional loan with an interest rate that changes periodically, usually in relation to an index. The introductory rate (the teaser rate) is often lower than the rate available on a fixed-rate mortgage, but the rate may change at any time after the introductory period, resulting in sometimes sizable increases in your monthly mortgage payment. Adjustable-rate loans are typically the recommended option for buyers who anticipate declining interest rates (to avoid being locked into a higher rate), who plan on living in the home for a limited number of years or who expect to pay off the loan before the interest-rate adjustment period is reached.
- FHA (Federal Housing Administration). Many first-time homebuyers can qualify for FHA loans. These typically have less rigid borrowing requirements with low down payments, reasonable credit expectations, and more flexible income requirements. A home financed with FHA loans must be the borrower's primary residence and must be owner-occupied (no investment or rental properties).
3. Contact Several Lenders.
Mortgage loans are available from several types of lenders – thrift institutions, commercial banks, mortgage companies and credit unions – and you can shop online, by phone or in person. To find lenders and look up rates:
- Try an Internet search for "[your city, state] mortgage."
- Compare rate averages at financial information aggregators l www.bankrate.com.
- Visit a real estate database website such as www.zillow.com, www.trulia.com or www.realtor.com, and enter your zip code in the mortgage page.
- Visit direct lender sites such as www.bankofamerica.com or www.chase.com.
Interest rates fluctuate, and different lenders may offer promotions for certain loan products. You'll likely receive a different quote from each lender, so you'll have to shop around to find the best deal. To keep the comparisons fair (apples to apples), provide each lender with the same information and make sure you are asking about the same loan: for example, a $250,000 30-year fixed-rate loan with no points.
Remember to compare longer and shorter terms – a 15-year mortgage may have a higher interest rate and monthly payments, but cost significantly less in the long run because you have 15 fewer years of interest payments.
You can also work with a mortgage broker who finds a lender for you and arranges the transaction (note: brokers will contact multiple lenders on your behalf, but they are not obligated to find the best deal for you unless they are under contract to act as your agent). Some financial institutions act as both lenders and brokers. Since brokers are typically paid a fee for their services in addition to the lender's origination or other fees, it's important to find out if a broker is involved – so ask if you're unsure.
4. Add in the Additional Costs.
The lowest advertised interest rate may not necessarily be the best option since fees can significantly drive up the cost of a mortgage. In general, a mortgage with higher fees will have a lower interest rate, but it's important to ask about loan origination or underwriting fees, broker fees, and settlement or closing costs. Some fees are paid when you apply for a loan (i.e., the application and appraisal fees), while others are settled at closing. Ask the lender which fees you will be charged and what each fee covers.
Points. Points are fees paid to the lender (or broker) and are typically linked to the interest rate: The more points you pay, the lower your interest rate. One point costs 1% of the loan amount and reduces your interest rate by about 0.25%. To find out how much you'll actually end up paying, ask for points to be quoted as a dollar amount instead of just the number of points. In general, people who plan on living in a home for a long time (10 or more years) should consider points to keep interest rates lower for the life of the loan. Paying a lot of money up front for points may not be worth it if you plan on moving in a shorter amount of time.
Once a lender has made you an offer, you may be able to negotiate for better terms. Ask the lender to write down all the costs associated with the loan – interest rate, fees, points – and then find out if it will waive or reduce any of the fees or offer you a lower interest rate (or fewer points). You can also ask if the lender will offer you better terms than you've found elsewhere. Once you are happy, ask for a written lock-in that includes the rate you agreed upon, the period the lock-in lasts and the number of points (if any) to be paid.
The Bottom Line
A mortgage is a long-term financial obligation, and the rate you pay substantially affects the overall cost of buying your new home. A 0.5% difference in interest rates, for example, can save or cost you tens of thousands of dollars over the life of a loan, so it pays to shop around to find the best mortgage rate for which you qualify.