If buying a home might be the largest single investment you ever make, the mortgage you need to finance it will probably be the biggest debt you ever assume. A mortgage is a long-term financial obligation, and the mortgage rate you pay substantially affects the overall cost of your new residence. A 0.5% difference in interest rates (which determines the size of your monthly payments), for example, can save or cost you tens of thousands of dollars over the life of a loan.
So, it makes financial sense to shop around for the lowest rate you can qualify for. Here are the six 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 terms 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 obtaining 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 an inquiry, credit agencies recognize that mortgage-related queries result in a single loan (and not multiple new lines of credit), so they'll cut you some slack – provided you can do your loan-hunting within a focused period. 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. Mortgages fall into two basic types: government-backed and conventional.
- Conventional loans, which represent around 65% of all mortgages issued, are offered by private lenders (thrift institutions, commercial banks, mortgage companies and credit unions); depending on their size and criteria, they may also be guaranteed by the federally-sponsored agencies Fannie Mae and Freddie Mac.
- Government-backed loans are also obtained through private lenders, but they are insured, either completely or partially, by the U.S.. government. These typically have less rigid borrowing requirements with low down payments, lower credit expectations, and more flexible income requirements. However, they must be the borrower's primary residence and must be owner-occupied (no investment or rental properties). Aimed at first-time or low-income buyers – though anyone can apply – the best-known of these mortgages are FHA loans, backed by the Federal Housing Administration.
Also to consider: what the nature of the financing you want. Again, these fall into two basic categories:
- Fixed-rate mortgage. A fixed-rate (or "plain vanilla") mortgage is a loan that has a set – that is, the same – rate of interest for the entire 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 loan with an interest rate that changes periodically, usually in relation to an index. The introductory or 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.
3. Contact Several Lenders
Shop online, by phone or in person. To find lenders and look up rates, try our mortgage calculator tool:
Keep in mind that loan officers get paid off of the transaction that you make. That doesn't make loan officers bad people; it just means that you should do a little work on your own to make sure you understand the full variety of available options in the marketplace and the pros and cons of each of them.
You can also work with a mortgage broker who, for a fee, 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). They are also paid a fee by the lender in exchange for bringing business to that lender. Some financial institutions act as both lenders and brokers; it's important to find out if the institution is getting a broker involved – so ask if you're unsure.
4. Add in the Additional Costs
The lowest advertised interest rate you find may not necessarily be the best option: You have to look at fees, since they can significantly drive up the overall 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. Ask not just about immediate ones, but potential ones down the road, like prepayment penalties.
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.
By law, lenders are obligated to provide a Good Faith Estimate (GFE) of the total closing costs associated with a mortgage, including information about total monthly expenses (seeing the out-of-pocket dollar amount per month can be a highly useful and understandable way to compare costs). Some loan programs require mortgage insurance premiums for all applicants regardless of down payment amount, and this information is listed on a GFE for easy comparison. GFEs require lenders to accept the loan application as long as the applicant meets the criteria provided by the lender. This document is not a loan offer, but it does obligate the lender to accept the applicant under the terms listed if the applicant has the available funds and credit approval required. Generally, part of the application information will be validated before the lender will offer a GFE. GFEs provide a way for the applicant to review a summary of the financial terms of a mortgage loan and compare offers from multiple lenders and multiple loan programs. This document does not require the applicant to apply for a loan and does not obligate the applicant to anything besides the provision of truthful information.
Once a lender has made you an offer, you may be able to bargain 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). If you are already a client of the lender's, definitely make that known – or ask if doing other business with them would make a difference. Bank of America Corporation, for example, offers reduced fees based on the amount a customer keeps in a Bank of America banking or Merrill Lynch investment account.
You can also get a little competitive spirit going, asking if the lender will match the terms than you've found elsewhere. Mortgage companies are constantly battling one another for the finite business out there. Particularly during down markets when fewer buyers are there for the taking, lenders frequently slash fees to get customers on board. A customer who shops around with multiple lenders and lets each know it is competing with several others stands a good chance of paying lower mortgage fees than a customer who does business with the first lender that calls.
Once you are happy, ask for a written lock-in that includes the rate you agreed upon, the number of points (if any) to be paid the period and the period the lock-in lasts. Most lenders charge a non-refundable fee for locking in the interest rate and points, but given the speed bumps that can occur on the road to approval, it may well be worth it.
6. Get It in Writing
Once you decide to go with a lender, finish the application and obtain a pre-approval letter. This is much more thorough than a GFE – but more of a commitment as well. Pre-approval is only given after all income verifications, credit checks, funding is secured, and all necessary information has been validated and accepted by the lender. Pre-approval letters are offers to loan money and are legally binding upon the lender; they can be revoked or substantially changed only if the borrower does not meet the full terms of the agreement to loan. A potential buyer having a pre-approved mortgage provides the seller and other interested parties with official proof of the mortgage offer and intent of the lender to loan money. This document allows the purchase or refinance of property to move forward.
Picking the Best Rate
Even before you actually contact any lenders, you can get a sense of what they're offering via a digital search and the use of a mortgage rate calculator (see Finding the Best Mortgage Rates). Interest rates fluctuate, and different lenders may offer promotions for certain loan products. To keep the comparisons 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 mortgage with no points.
Remember to compare the total dollar amounts of different-length terms, too. A 15-year mortgage may have a higher interest rate and monthly payments, but cost significantly less in the long run than a 30-year, because you've paid off the debt a decade and a half earlier.
Picking the Best Lender
On the service side, getting your questions answered in a timely and accurate way is an important element of the process. Applying for a loan requires quite a bit of paperwork as well as the collection and dissemination of a significant amount of personal information. Having a single, reliable point of contact for your questions can make the difference between a smooth, easy process and a tough experience.
Having the loan ready in time for your closing is another important consideration. Final documentation is often unavailable until days or even hours before the closing, and coordinating the schedules of the various parties involved in the transaction can be a challenge. A dependable lender will help to keep everything on track and on time and make a significant contribution to your personal peace of mind.
Although dealing with someone in person is usually preferable, you might save money by using an online lender. In theory, because online lenders have lower overhead, they can pass on the savings to consumers in the form of lower interest rates and fees. But you still need to comparison shop – don’t make the mistake that nearly half of regular mortgage borrowers make and only get a quote from a single lender. And an online lender might not be right for you if you need a lot of hand-holding during the process.
Studying a company's history, its pricing and the prevailing sentiment of previous customers provides a glimpse into whether that lender deserves to loan you money.