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For many of us, a home mortgage will be the biggest and longest financial obligation of our lives. So getting a good mortgage rate is essential. A mere 0.5% difference in interest rates can either save or cost you tens of thousands of dollars over the life of the loan.
- Even a small difference in interest rates can add up over time, so it pays to shop around for a mortgage with a competitive rate.
- In addition to the traditional sources of mortgages, such as banks and credit unions, there are now alternatives such as nonbank financial companies.
- The rate you can get on a mortgage will depend on the type of loan, the term of the loan, your creditworthiness, and other factors.
Check Your Credit Score
Credit scores help lenders determine who qualifies for mortgages and the interest rates they’ll pay. Generally speaking, the higher your credit score, the better the terms. For this reason, you should check your credit reports at the three major credit bureaus at least six months before applying for a mortgage and correct any errors that could be dragging down your credit score.
Starting early also gives you some extra time to demonstrate good credit habits, such as paying all your bills by their due date, if that has been a problem in the past. You can check your credit reports for free at least once a year at AnnualCreditReport.com, the official website for that purpose.
As to your actual three-digit credit score, you can obtain it free of charge from some credit card issuers and credit-related services. Investopedia also publishes a list of Top Sources for Free Credit Scores. If you know your credit score, some online mortgage calculators will let you plug it in to see the interest rates you'd currently qualify for.
Note that mortgage shoppers generally aren't penalized for too many credit inquiries from lenders, as they might be if they were applying for a lot of credit cards at one time. Credit bureaus can tell when a prospective homeowner is simply making the rounds of lenders, and they recognize that mortgage-related queries usually result in a single loan. Consequently, they cut house-hunters some slack and don’t allow the multiple queries to negatively affect their credit scores, provided that the loan-shopping occurs within a fairly narrow time period. For example, the FICO credit scoring model disregards multiple inquiries when they happen within a 30-day window.
Weigh the Different Types of Mortgages
There are two basic types of home mortgages, fixed and adjustable, and which one you choose can have a major effect on the rate you'll pay.
A fixed-rate (or “traditional”) mortgage carries a set interest rate that won't change during the term of the loan. That term might be, for example, 10, 15, 20, or 30 years, although loans with shorter or even longer terms may be available.
The longer the term of your loan, the lower your monthly payments will be, but the more you'll pay in total interest costs over the life of the loan.
Fixed-rate loans can be a good choice for homeowners who appreciate the predictability of knowing what their monthly mortgage payments will be for years into the future.
Adjustable-Rate Mortgage (ARM)
Also called variable-rate or floating-rate mortgage, an adjustable-rate mortgage is a loan with an interest rate that can change periodically, usually in relation to an index. While the initial rate is generally lower than the rate on a fixed-rate mortgage, the rate can rise after that, subject to the terms of the loan. Most ARMs have caps, or limits, on the size of each rate adjustment and how high the rate can go in total.
ARMs can be a good choice for buyers who anticipate declining interest rates in the years ahead or who plan to move before their loan's interest rate is adjusted. For example, a 5/1 ARM has a fixed interest rate for the first five years, after which the rate can adjust annually.
Shop Multiple Lenders
Mortgage rates can vary from lender to lender, even for the very same type of mortgage. So it pays to shop around, which you can easily do online, at least to get started.
Banks, savings and loan associations, and credit unions are the traditional sources for mortgages. In recent years, nonbank financial companies have also gained a major share of the mortgage market.
Any financial institution that you already have a relationship with could be a good place to start. In addition to knowing you, they may have special offers for established customers. At this writing, for example, Bank of America offers a fee reduction of $200 to $600 for mortgage applicants with a Bank of America bank account or a Merrill investment account.
Using a mortgage broker is another option. Mortgage brokers work with a number of different lenders and can help you find a suitable mortgage, sometimes with a better rate than you could get on your own. However, they are often paid commissions by lenders, which may give them an incentive to steer you toward a particular lender even if there are better options available. To find a reliable mortgage broker, ask your real estate agent, lawyer, or other knowledgeable local source.
Ultimately, there's no substitute for doing at least some mortgage shopping on your own. Even if you end up working with a broker, you'll at least know whether any deal the broker comes up with is truly a good one.
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Learn the True Cost of the Mortgage
Low advertised interest rates can distract borrowers from the actual cost of a mortgage. In comparing interest rates from different lenders, the figure to focus on is the annual percentage rate, or APR.
The APR, which will be higher than the basic interest rate, represents how much you'll pay for the loan, including any additional fees charged by the lender. It is calculated on the assumption that you'll keep the loan for the entire term, so costs are averaged over that period.
Another consideration is "points." While this term sometimes refers to additional fees that are accounted for in the APR, it can also refer to what are known as discount points. Discount points are an optional upfront payment you can make in return for a lower interest rate. Each point is equal to 1% of your loan amount.
In general, people who plan to live in a home for 10 or more years may want to consider paying points as a way to keep their interest rate lower for the life of the loan (assuming they can spare the upfront cash). On the other hand, paying a large sum of money for points makes little sense if you expect to move after a short period of time.
Knowing the real cost of a mortgage is not only important for comparing different lenders' offerings. It can also give you a better idea of how much you can afford to pay for a home without stretching yourself too thin. One very general guideline is that your mortgage payment, property taxes, and insurance usually shouldn't exceed 28% of your gross income.
Ask for a Pre-Approval Letter
Once you have found one or more lenders that seem like good prospects, you should ask them for a pre-approval letter. A pre-approval letter isn't a formal loan offer but indicates that the lender has performed a credit check or other investigation of your financial affairs and would be willing to lend you up to a certain amount of money.
Being pre-approved for a mortgage can give home buyers an edge in the real estate market because prospective sellers will know that they're serious about any bid they make and have the money to back it up.
As the Consumer Financial Protection Bureau points out, "Getting a preapproval doesn’t commit you to using that lender for your loan. Wait to decide on a lender until you've made an offer on a house and received official Loan Estimates from each of your potential lenders."
Obtain Loan Estimates
If you have found a property you want to buy, you can obtain a Loan Estimate from the lenders that you are considering. This is a standard three-page document that details the type of loan, estimated interest rate, monthly payment, and total closing costs, along with estimated tax and insurance costs.
A Loan Estimate is not a guaranteed offer of a mortgage but indicates the terms you can probably expect if you go with that lender. Before it commits to offering you a mortgage the lender will typically ask for additional information about your finances.
Once lenders provide estimates, borrowers can sometimes negotiate for better terms, especially if they are able to make an above-average down payment or if they have excellent credit histories. This is most likely to work in a down real estate market, when lenders are hungry for business. But there is no harm in trying.
Formalize the Deal
Loan estimates are typically good for 10 business days, after which they expire. If you have decided on a particular lender you should notify them during that time frame and follow up with any additional information they request. You will also have to pay an application fee.
If you are happy with the proposed terms, you can request a written lock-in or rate lock. That will keep the loan's interest rate from going up if market interest rates change before the deal is finalized. Most lenders charge a fee for this, but it can be worth it if you've nailed down a good rate and rates are looking volatile.
Getting a good mortgage rate takes a little work, but it can pay off in the long run. Even after you've obtained a mortgage and settled into your new home, you may want to keep an eye on interest rates. If they go down, or your credit score has risen substantially, you might want to consider refinancing into a new mortgage, with an even better rate.
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