Buying a home may be the biggest and most important financial decision of your life, and will likely require a mortgage to fund the purchase. As home-buying technology has progressed, the process of finding the best mortgage rates can all be done online – with handy instruments to help you find the best option for you, such as Investopedia's mortgage calculator tool. This sort of calculator is a good way to familiarize yourself with the mortgage market in your area – the types, terms and rates available.
Ah, but knowing the numbers is just Step One. You should also understand what influences them and whether they represent a good deal for you, or not. So after you calculate, read on to understand the different categories of mortgages, plus some shopping tips on how to snag a quality loan.
The calculator asks about multiple factors to help you narrow the options best suited for your specific needs. You can compare payments between short and long contracts, evaluate a lower initial interest rate on an adjustable rate mortgage (“ARM”) versus a more traditional fixed rate option, or determine whether an interest-only (“I-O”) mortgage makes the most sense for you.
Below is a list of terms you're likely to encounter as you use the mortgage calculator:
Credit Score: The credit score is the numeric expression of a person’s creditworthiness.
Location: You must select the state in which the mortgage will be taken out, then narrow the location by either the closest city or ZIP code.
Loan Amount: This would be the equivalent of the estimated value of the home (minus your down payment) or the remaining balance on your incumbent mortgage that you would like to refinance.
Mortgage Points: A mortgage point is equal to one percent of the total amount of a mortgage. There are two types of points: discount points, which represent prepaid interest on a mortgage; and origination points, which are a fee the mortgage lender may charge a borrower.
Percent Down: Also known as a down payment, or an initial payment made when something is bought on credit.
Products: The type of mortgage you are interested in, such as a traditional fixed-rate mortgage, an ARM, or an I-O mortgage. The ARM option shows a ratio such as "7/1,” which represents the number of years the mortgage carries a fixed interest rate. After the pre-set number of years (in this case, 7), the interest rate adjusts once a year (the 1) for the remaining term of the loan, according to three factors: the level of the index that the mortgage is tied to, such as the LIBOR; the ARM margin established at the onset of the loan; and the mortgage cap.
Purchase or Refinance: Purchase mortgages are used to finance the purchase of a home. Refinances are used to replace an older loan with a new loan offering better terms, for a fee.
Depending on factors such as your credit score, employment history and debt-to-income ratio, the calculator may have come up with – and a lender may offer you – a prime rate mortgage, a subprime mortgage or something in between, called an “Alt-A” mortgage. Let’s take a quick look at the different mortgage categories and see what affects which one you qualify for.
Prime mortgages meet the quality standards set forth by Fannie Mae (the Federal National Mortgage Association) and Freddie Mac (the Federal Home Loan Mortgage Corporation), the two government-sponsored enterprises that provide a secondary market in home mortgages by purchasing loans from originating lenders. According to the Federal Reserve, a prime residential mortgage is “a mortgage for a borrower whose credit scores are 740 or higher, whose debt-to-income ratios are lower than average and whose mortgage features the standard amortization schedule common to a fixed-rate or an adjustable-rate mortgage.”
Candidates for prime mortgages also have to make a considerable down payment – typically 10% to 20% – on the residence, the idea being that if you’ve got skin in the game you’re less likely to default. Because borrowers with better credit scores and debt-to-income ratios tend to be lower risk, they are offered the lowest interest rates – currently an average of 4.6% for a 30-year fixed rate mortgage – which can save tens of thousands of dollars over the life of loan.
Subprime mortgages are offered to borrowers who have lower credit ratings and FICO credit scores below about 640, though the exact cutoff depends on the lender. Because of the increased risk to lenders, these loans carry higher interest rates – such as 8% to 10%.
There are several kinds of subprime mortgage structures. The most common is the adjustable rate mortgage (ARM), which charges a fixed-rate “teaser rate” at first, then switches to a floating rate, plus margin, for the remainder of the loan. An example of an ARM is a 2/28 loan, which is a 30-year mortgage that has a fixed interest rate for the first two years before being adjusted. While these loans often start with a reasonable interest rate, once they switch to the higher variable rate the mortgage payments increase substantially.
Alt-A mortgages fall somewhere in between the prime and subprime categories. One of the defining characteristics of an Alt-A mortgage is that it is typically a low-doc or no-doc loan, meaning the lender doesn’t require much (if any) documentation to prove a borrower’s income, assets or expenses. This opens the door to fraudulent mortgage practices, as both lender and borrower could exaggerate numbers in order to secure a larger mortgage (which means more money for the lender and more house for the borrower). In fact, after the subprime mortgage crisis of 2007-08, they became known as “liar loans” because borrowers and lenders were able to exaggerate income and/or assets to qualify the borrower for a bigger mortgage.
While Alt-A borrowers typically have credit scores of at least 700 – well above the cutoff for subprime loans – these loans tend to allow relatively low down payments, higher loan-to-value ratios and more flexibility when it comes to the borrower’s debt-to-income ratio. These concessions enable certain borrowers to buy more house than they can reasonably afford, increasing the likelihood of default. That being said, low-doc and no-doc loans can be helpful if you actually have a good income but can’t substantiate it because you earn it sporadically (for example, if you’re self-employed).
Because Alt-As are viewed as somewhat risky (falling somewhere between prime and subprime), interest rates tend to be higher than those of prime mortgages but lower than subprime – somewhere around 5.5% to 8%, depending on the lender and the borrower’s situation.
Obviously, the higher the interest rate, the more you pay each month, and the more you ultimately pay for your home. To compare, let’s take a look at a 30-year fixed-rate mortgage for $200,000.
At the prime rate – 4.6% in this example – your monthly payment would be $1,025. Over the life of the loan, you would pay $169,103 in interest – so you’d actually pay back a total of $369,103.
Now assume you get the same 30-year fixed rate mortgage for $200,000, but this time you are offered a subprime rate of 6%. Your monthly payment would be $1,199 and you’d pay a total of $231,676 in interest, bringing the total amount you pay back to $431,676. That seemingly small change in interest cost you $62,573.
What’s important to realize is this: Just because a lender offers you a mortgage with an Alt-A or subprime rate doesn’t mean you wouldn’t qualify for a prime-rate mortgage with a different lender. Lenders and mortgage brokers may be competitive, but they generally are under no obligation to offer you the best deal available. It’s well worth the effort to shop around: Taking the time to find a better interest rate can save you tens of thousands of dollars over the course of a loan.
This is not the time to let somebody else do the shopping for you. As we saw just now, the terms you get can make a sizable difference in what you pay to borrow the same amount of money.
How do you avoid paying more than you need to for your mortgage? Certainly, compare the offers you get by running them through your online mortgage calculator to see what your payments and interest will be. And as you do – or even before you do – follow the steps below.
If you’re looking for a home right now, getting your finances in great shape may be tough. So try to think ahead; maybe even postpone house-hunting until you can clean your financial house.
In general, you need outstanding credit. Before you’re even considered for a mortgage, conventional lenders will look for a credit score of at least 700 and, as we said above, one of 740 for a prime-rate mortgage. FHA loans come with more relaxed standards, but more stringent conditions. So do what you can to get that score up by paying off those credit card balances and other personal debts, to the extent you can.
Even a 20-point difference in your score could move your rate up or down more than 0.25%. On a $250,000 home, one-quarter of a point could mean an extra $12,000 or more paid in interest over the life of the loan.
Second, save up! The more you can put down, the lower your mortgage payment and the less interest you’ll pay over time. A higher down payment could even mean a lower interest rate. Coming up with a 30% down payment (vs. the conventional 20%), for example, could drop your rate more than 0.5%.
The interest rate is important, but there’s more to compare. Is there a prepayment penalty if you decide to refinance at some point? What are the total closing costs? Closing costs generally amount to 2% to 5% of the price of the home. If your home costs $150,000, expect to pay $3,000 to $7,500 in costs. That’s a big range, so it behooves you to see what a lender typically charges.
Though they do count towards the overall cost of your mortgage, closing costs are a one-time hit. But there's another bite that keeps on biting. If your down payment is less than 20%, you’re considered higher risk, and required to carry PMI, or private mortgage insurance. This makes you a safer bet for the lender. Trouble is, you're the one paying for it – to the tune of 0.5% to 1% of the entire loan each year. That can add thousands of dollars to what it costs to carry the loan. If you do end up having to pay for PMI, make sure it stops as soon as you've gained enough equity in your house through your mortgage payments to be eligible.
Let’s say you get the most amazing mortgage deal. Congratulations, but move fast. The interest rate – and possibly other conditions – are locked in for a set amount of time. You have to close within the lock period or risk losing the deal. Don’t procrastinate. (See Got a Good Mortgage Rate? Lock It In!.)
Most of the work involved in getting the lowest mortgage rate happens long before you’re ready to apply. A stellar credit score and a sizable down payment are the best ways to lower your rate.
But don’t blindly trust your bank, realtor or mortgage broker to get you the best terms. They may have a financial incentive to steer you in a certain direction. Do your own shopping, mortgage calculating and comparing. Also, remember that just because you qualify for X amount of mortgage, there’s nothing that says you have to borrow that much.