There’s more to finding a mortgage lender than simply securing the lowest interest rate. Just ask Elena Loutskina, professor of business administration at the University of Virginia’s Darden School of Business. “If the consumer wants to be protected, it’s the education that’s the most important thing,” she told Investopedia recently.

Loutskina spoke at length about what consumers need to know, what questions to ask, and how to find the best mortgage lender in the complicated and sometimes confusing world of home buying. Our edited conversation follows.

Lenders Come in Many Forms

Investopedia: Thanks for agreeing to speak with us, Elena. Perhaps we could start with the basics. What is a mortgage lender?

Loutskina: The question is simple and complex at the same time. We have different actors implementing different parts of the value chain in the mortgage market. Some interact with borrowers directly—such as a bank, mortgage broker, mortgage company, or an online portal like Lending Tree.

Others originate mortgages, and it could be the same or a different entity. For example, mortgage brokers do not originate mortgages. Different actors finance mortgages or provide the money that flows to the borrower.

Then there are actors that hold mortgages on their balance sheet for the duration or the maturity of that debt, up to 30 years.

A bank, for example, could fill all these roles. It could interact with the borrower, originate the loan, finance the loan, and hold the mortgage ’til maturity. Or there could be a different entity for each role. For example, the process can start with a mortgage broker, then go to a bank that originates the loan. This is the original lender. The bank may keep the loan on its balance sheet or sell it, say to Fannie Mae or Freddie Mac. Instead of a bank, the originator could be a financial or mortgage company that borrows money in a wholesale market or from other financial institutions and originates the mortgage.

This is where the notion of who the lender is becomes very fuzzy. Who is it? Is it someone you interact with to get your loan? Is it someone who underwrites it? Is it someone who initially funds it? This is where the fuzziness begins.

Investopedia: OK, it can be confusing for sure. I understand there can be different actors for each step. How can the consumer sort it all out?

Loutskina: It is not clear to me why borrowers need to sort out all steps in a mortgage origination process. My mortgage, for example, was transferred between financial companies multiple times, yet it did not change my financial obligations. Borrowers need to focus on identifying credible agents, meaning banks or mortgage brokers, that will offer them a quote and then focus on the best terms available to them.

Problems with Poor Enforcement and Shadow Banks

Investopedia: In 2015, you wrote about the financial crisis of 2009 and mentioned the history, before the crisis, of inconsistent enforcement of existing regulations. So, two questions. What is the status of inconsistent enforcement, and how does that compare to the problem of shadow banks? It seems both of these could impact consumers and how they shop for a lender.

Loutskina: We definitely observed differences in regulatory exposure and enforcement between banks and financial corporations. Financial corporations do not carry deposits. And since they do not carry deposits and are not insured by Federal Deposit Insurance Corporation (FDIC), they are not subject to the same level of regulation. We call them shadow banking institutions or non-depository financial intermediaries that implement the same functions as banks do.

The Consumer Financial Protection Bureau (CFPB) that was established after the financial crisis significantly changed the enforcement equation. Now there is a sufficient credible threat aimed at nonbanks that regulations can be enforced.

From the consumer’s perspective, one of the most important things is to be informed. I’m a much bigger believer in consumer education about financial markets than the enforcement of something like the Home Ownership and Equity Protection Act. That’s because regulations can only change behavior on the margins. If the consumer wants to be protected, education is the most important thing.

Investopedia: What are some examples of that?

Loutskina: Consumers need to invest in understanding the pricing of the mortgage and make sure that fair disclosure regulations apply, meaning they get the information in advance before they get a mortgage. If they are surprised at the point of signing mortgage paperwork, this is probably a bad sign.

And they need to ask a lot of questions: “What is going to be my monthly payment?” “Is it going to remain fixed over time?” “Do I need mortgage insurance?” “How will the escrow account work?” This is something that is the best protection for the consumer on a front end.

How to Search for a Lender

Investopedia: In terms of searching for a mortgage lender, what are the sorts of things homebuyers should be thinking about when they’re searching?

Loutskina: The most obvious advice is, don’t borrow from shady individuals with a name you cannot verify. Other than that, there is very little difference between Bank of America, University of Virginia Credit Union, BBVA bank, or Lending Tree. 

It’s a matter of pricing. My recommendation to consumers is to cast a broad net. Reach out to your local bank, reach out to online portals, reach out to local mortgage brokers, ask all of them what they can offer you. It’s a low-cost search, and it will allow you to better understand the prices that are available in the marketplace. This broad-net approach will also allow you to negotiate.

Investopedia: Anything else consumers should be aware of?

Loutskina: Consumers need to understand the tradeoffs available to them in terms of up-front points and the mortgage interest rate. Points represent the up-front fee borrowers pay for the origination as a percent of the total amount. Some prefer to pay a fee up front and lower the interest rate for the duration of the mortgage—for example, 30 years. Others want to avoid paying the origination fee and even get the lender to cover some of the closing costs. But that will come at the expense of a higher interest rate.

Investopedia: What about the appraisal of the property you want to buy? How does that fit in?

Loutskina: This is important. You need to find out whether your lender will require an assessment or appraisal of the property value and how much that weighs into a decision to lend you the money. These days, when you have a good credit history and a 20% down payment, lenders frequently do not require an appraisal.

You shouldn’t be caught off guard when you sign a contract to buy a house without any contingencies and then go for an assessment of the property value, and that assessment comes in low and the mortgage lender refuses to originate your mortgage.

The Hidden Cost of an Appraisal

Investopedia: Why would a lender not require an appraisal of the property?

Loutskina: Appraisals are important for the lender, but they are expensive. Appraisals, which involve having someone come to the sellers’ house to ensure that the property value is above the mortgage amount and thus protect banks against the risk of nonpayment, is expensive, and a borrower ultimately covers this cost.

The price of an appraisal is in-loaded in the mortgage points, or closing costs, or the interest rate. When you have a buyer with a good credit score and more than 20% down payment, lenders might decide not to incur the additional expense. A good credit score and 20% down payment might be sufficient mitigating factors when it comes to lenders’ risk.

Pre-approval as Part of the Process

Investopedia: What about pre-approval? That is something that comes up frequently. Is it an advantage for the borrower?

Loutskina: I think so. Pre-approval provides an opportunity to ask if you can actually get this much money given your credit history and income. Pre-approval is a great way for the lender and the borrower to come to a consensus without a formal commitment.

Borrowers can think of pre-approval as a tentative confirmation from a lender. “If everything you’re telling me is correct and the house is worth as much as you are willing to pay for it, then I will be willing to give you this loan on these conditions today.” But in the mortgage market, borrowers are frequently trying to figure out how much you can borrow in March to close on a house in July or August. Quite a bit of time is going to pass between March and July or August. Situations can change. Lenders’ finances can change. Borrowers’ intent to buy a given house might change.

Typically, a pre-approval offer (but not commitment) is good for 90 days. Pre-approval is a solid indication to a borrower on how much they can borrow and on what terms. But don’t be surprised if by the time you are ready to sign a contract, a bank might decide to renegotiate. I suggest that borrowers keep in touch with their mortgage agent (lender) that the commitment they received in March is still good in June or July.

Borrowers can lock in the mortgage conditions for an extra fee. Essentially, they can buy insurance in case something happens between now and August and market conditions change. But borrowers need to be aware that if their credit history significantly deteriorates or house appraisal value comes in below original expectations, the bank can still change the mortgage conditions.

However, by locking in the mortgage conditions, a borrower is assured, barring any changes in credit history or house value, they still can get a loan under the pre-approved conditions. Yet if, for example, they don’t sell their previous house or if their new house does not pass the inspection, they don’t have to enter a mortgage loan contract.

Is the Lowest Interest Rate the Holy Grail?

Investopedia: The goal in home buying seems to be to get the lowest interest rate possible. Is that ultimately the most important thing about the choosing a lender?

Loutskina: No. I think there are three factors working in concert. The two most important are the size of the loan relative to the property value, and the interest rate. The larger the down payment, the less risk for the bank. This is where you can expect slightly lower interest rates. But as your down payment evaporates, your interest rate might go up. Sometimes you don’t have a choice, or you want to get a bigger loan because the interest-rate environment is so friendly.

The third factor is the points that you pay for a loan origination up front. If you have the money right now for a down payment and to cover the points, that’s one thing. If you don’t, that’s a different story. So the second tradeoff borrowers face is higher points (fee) up front vs. higher interest rate over the life of a mortgage.

Those are the three most important factors. Others could include the fact that not every bank would be willing to give you pre-approval in March and close the deal in August. You must make sure the bank is willing to stick with its original terms.

The past 18 months have taught us that economic conditions can change radically. I think banks are going to be cautious in committing to originate a mortgage six months down the road on a fixed set of conditions.

COVID-19: Lessons Learned

Investopedia: You’re right. The fact that economic conditions can change is something we’ve learned during the pandemic. How has this affected, from a consumer’s point of view, working with lenders?

Loutskina: The pandemic definitely changed the real estate market. We see an exodus of people from big cities to suburbs. We also see a structural shift in what is a must-have in a house: People want to have a home office now. It’s less about bedrooms. It’s about having a separate space to work to avoid any disturbances by family members.

This has created enormous pressure on housing demand, and house prices swelled. By some estimates, we see a 13 to 15% increase in the median house price in the U.S. A majority of metropolitan areas are going through a building boom, with developers trying to capitalize on these trends. It smells awful like the boom pre-2007 financial crisis.

What banks and homebuyers should care about is whether this effect is temporary or permanent. If the trends reverse, say as a result of companies imposing “back to office” requirements, this can reverse migration and cause house prices to decline. Some borrowers might find themselves underwater, holding a property valued at below their debt obligation.

Final Thoughts

Investopedia: Is is there any area or anything that’s of special interest to you that that I didn’t ask you about that you’d like to see included in our communicating to consumers?

Loutskina: One of the biggest problems for homebuyers is a lack of understanding of mortgage market basics. This might lead to bad outcomes even when lending agents have no evil intent.

When you’re making such a huge financial decision in your life, like buying a house and getting a loan that you will be paying off for 30 years, my biggest advice is: Spend time to make sure you understand the basic terms of mortgage lending.

If you see or hear something you don’t understand, talk with your lending agent. Don’t be afraid to ask questions at any point in the process. Even with all of my education and knowledge of the industry, when I first got my mortgage, the volume of paperwork was overwhelming. It’s key to ask questions all the way through to make sure that your expectations about the product you’re getting are met.