When seeking the best deal on a mortgage, borrowers often believe there is only one variable to compare: the interest rate. Savvier borrowers realize that there are closing costs to consider as well and may claim that annual percentage rate (APR) is the all-encompassing standard for comparison, as it includes closing costs in its calculation.
Obviously, if all else is equal, a lower interest rate or APR is better, but rarely is “all else” truly “equal.” Although this article will show you how to compare rates and costs, keep in mind that crunching the numbers is one of the last steps you should take before committing to a loan program/ lender. There are a handful of things that should be considered prior to compare loan costs.
Although all for-profit entities share the common goal of making money, the approach to doing so can be vastly different from company to company. Never is this difference so pronounced as in the mortgage industry. As a borrower, you have to beware of everything from hidden fees, to incompetence, to downright nefarious or illegal activity. And although the mortgage industry is regulated now more than ever, that does not mean you can trust every lender to do the right thing.
It is important to do your homework in advance; be skeptical of cut-rate lenders, and remember that you usually get what you pay for. That doesn’t mean, however, that you can’t get a cheap mortgage with a good lender; it simply means that you shouldn’t automatically write off a lender just because they quote you a higher price. Remember that prices are negotiable in the mortgage industry, so it may just take some posturing (shopping around) to find a good deal with the right company.
Don’t let the word ‘features’ fool you. If two companies offer you similar interest rates and closing costs but one of them includes a loan feature like a prepayment penalty or a balloon payment, the options are far from equal. Now with a sizable discount, you may decide that the inclusion of one of these loan features is a fair tradeoff, but be sure you are aware specifics of the loan feature and the added risk it presents you.
A Conventional loan is not equal to an FHA loan, is not equal to a VA loan, is not equal to a Jumbo, even if they have the same interest rate and APR. Each of these different loan programs have their respective merits and drawbacks.
This one is quite obvious, but clearly, when you compare one company’s interest rate on a 15-year fixed to another company’s 30-year you are comparing apples to oranges. Thus, you’ll have to determine which term fits best with your personal and financial goals before you shop around or compare costs.
Fixed vs Adjustable
If you lived through the Great Recession (which is presumably everyone reading this article) the term Adjustable Rate Mortgage (ARM) might cause flashbacks to a day when your 401k was plummeting, you were laid off work, your parents severely cut your allowance money, or worse. ARMs were indeed a major cause of the housing market crash in late 2007. Something to note, however, is that it wasn’t the existence of ARMs that caused the problem, it was that the wrong people were obtaining them at their lender’s guidance.
For a certain type of borrower, ARMs can make a ton of financial sense. Especially, if you are a short term borrower planning to sell in a few years, or if you are buying while interest rates are high. Therefore, it is important to educate yourself, and NEVER let a lender steer you into choosing an option that may not be in your best financial interest.
Mortgage insurance can show up in many forms, but no matter the form, the inclusion of mortgage insurance usually means there is a greater risk of default on a particular loan. Therefore, that heightened risk must be offset with an additional monthly charge. Ironically, although the borrower is the one paying for the insurance, the policy actually protects the lender against a borrower’s default, which means you really want to avoid it if you can.
While Conventional loans only carry mortgage insurance if a borrower puts less than 20% down, FHA loans carry mortgage insurance no matter what. And although VA loans don’t technically require mortgage insurance, they do require borrowers to pay a ‘funding fee’ (besides eligible disabled veterans), which is a relatively small amount by comparison but still worthy of consideration.
Buydown or Credits
This is where things get a little complicated, but if you get a good grasp of this concept then it can save you a ton of confusion when shopping for a mortgage. Contrary to popular belief, lenders do not offer one interest rate for each mortgage program; they actually offer a range of interest rates that you’ll be able to choose from. That means that rather than there being a set daily interest rate for a Conventional 30-year Fixed, there is actually more like 6-10 interest rates that are available to borrowers at different costs.
Negotiation aside, if you choose a lower interest rate on the available range, you will pay more out of pocket at closing, while if you choose an interest rate higher on that range your lender will actually credit you money to cover some of your closing costs making your out of pocket expenses much lower.
This additional charge or credit is expressed as “points,” and can be either positive or negative. One point = one percent of the total loan amount. For instance, if on a $200,000 loan, you were to opt for a higher interest rate and the rate you chose cost negative 0.5 points, you would receive a $1000 credit to help cover some of your closing costs, while the opposite is true if you chose a lower interest rate. The thing to note, however, is that this is still the lender’s asking price. By shopping around and leveraging other offers, lenders will almost always give you considerable discounts wherever you decide to be with respects to your interest rate.
Comparing Interest Rates
Okay, let’s assume you have covered all the bases above. Based on your goals, you have chosen the right program, the right term, and have narrowed down a list of reputable lenders. Now, can you simply compare interest rates or APR?
Unfortunately, the answer is still no. Even if you are comparing apples to apples (e.g. one Conventional 30-year Fixed without PMI to another) it is still possible to be getting a worse deal from a lender even if they are offering you a lower APR.
For those who are still shaky on this, according to Freddie Mac, “interest rate is the cost of borrowing the principal loan amount,” while “APR — or Annual Percentage Rate — is a broader measure of borrowing and includes not only the interest rate but also any other costs to get a loan such as discount points, insurance, and closing costs.”
When two lenders offer you the same rate with different closing costs, or vice versa, spotting the better deal is easy. With that said, many times one lender will show you a lower interest rate with higher origination charges (buydown), while another will show you a higher interest rate with lower origination charges (lender credit). In this case, how do you know which is a better deal?
Step 1: Get a “Loan Estimate” (LE) for Both Offers
All the information you will need to make an informed decision will be included in the LE. Just be sure that they offer you an actual “Loan Estimate” not a loan worksheet or good faith estimate as only LEs are legally binding.
For help reading a Loan Estimate, click here.
Step 2: Calculate the Difference in your Monthly Payment (x)
The first page of the LE will show your monthly principal and interest payment. Subtract one from the other to get the difference between your monthly payments (x).
Step 3: Calculate the Difference in Your Closing Costs (y).
The second page of the LE will detail your closing costs. Find “Total Loan Costs” (line item D on the left side), and subtract one from the other to get the difference in total loan costs (y).
Step 4: Find the Break-even Point (z).
The break-even point refers to the amount of time it takes to recoup the initial cost of buying a lower interest rate. To calculate this take the difference in total loan costs (y), divided by the difference in monthly payment (x), divided by 12 months. The result is the number of years it will take to recoup your investment (z). Usually, the break-even point on a rate buydown is between 5 and 10 years.
Step 5: Place Your Bet
Why is it necessary to find the break-even point?
As we know, APR is calculated over the full term of your loan (i.e. APR on a 30 year fixed averages all loan costs over 30-years). Almost never, however, does anyone carry a loan for a full 30 years without refinancing or selling their home. There are a ton of reasons one might refinance their mortgage from seeking a better interest rate to changing their term, to consolidating credit card debt, to buying a new boat.
If you choose to buy down your interest rate you are betting that you will not refinance or sell until after you reach the break-even point; otherwise, you will have paid all that money upfront never to recoup it in the long run. On the flip side, you might opt for the lender credit assuming that you will move soon, or that interest rates will go lower in the future. If things don’t work out the way you plan though, you’ll be stuck indefinitely with an interest rate that is higher than necessary.
This sort of interest rate comparison may seem 2.0, but it’s actually a really easy way to ensure that your mortgage aligns with your personal expectations, possibly saving you a boatload of money. Keep in mind that those expectations may change in the future, so unless you are confident in your intentions it may be best to choose an interest rate that is in the middle of the market, neither buying down or receiving a lender credit. Lastly, be sure to shop around to leverage a better deal no matter where your goals lie, because, in the end, this may save you more money than anything.
Frequently Asked Questions
1) Q: How do I get pre-approved?
First, you need to fill out an application and submit it to the lender of your choice. For the application you need 2 previous years of tax returns including your W-2’s, your pay stub for past month, 2 months worth of bank statements and the lender will run your credit report. Once the application is submitted and processed it takes anywhere from 2-7 days to be approved or denied. Check out our top lenders and lock in your rate today!
2) Q: How much interest will I pay?
Interest that you will pay is based on the interest rate that you received at the time of loan origination, how much you borrowed and the term of the loan. If you borrow $208,800 at 3.62% then over the course of a 30-year loan you will pay $133,793.14 in interest, assuming you make the monthly payment of $951.65. For a purchase mortgage rate get a quote here. If you are looking to refinance you can get started quickly here.
3) Q: How much should I save for a down payment?
Most lenders will recommend that you save at least 20% of the cost of the home for a down payment. It is wise to save at least 20% because the more you put down, the lower your monthly payment will be and ultimately you will save on interest costs as well. In the event that you are unable to save 20% there are several home buyer programs and assistance, especially for first time buyers. Check out the lenders that specialize in making the home buying experience a breeze.