Shopping for a mortgage usually means intense focus on the interest rates. Maybe you have a specific rate you want and will not settle for less. Some people assume the lower the rate, the better the deal. However, there are several other factors you should consider when shopping for a mortgage. Looking at the big picture will help you secure the best deal.
What are the Closing Costs?
The closing costs affect your APR or annual interest rate. You pay this “true” rate. Not all closing costs are included in the rate, though. The main lender charges are included, though. Third-party charges, such as appraisal fees and title fees are excluded. However, this gives you a better idea of the actual cost of the loan. The APR is usually higher than the quoted interest rate. You can use the APR and the closing cost quotes to pick the right lender/loan.
For example, if Lender A offers you a 4% interest rate, but has $10,000 in closing fees, the APR will be significantly higher. If Lender B offers you a 5% interest rate, but has $5,000 in closing fees, the APR will be lower. You then must decide which loan is right. Think about how long you will live in the home. Is this a long-term purchase or will you move in a few years? The longer you live in the home, the more sense it makes to take the lower interest rate and higher fees.
Should you Pay Points for Lower Interest Rates?
This goes along with the closing costs, but is worth its own section. Points come in two forms:
- Discount points
- Origination points
Discount points, as the name suggests, lower your interest rate. Lenders will quote you a standard rate based on your qualifications. If you want a lower rate, you can pay a discount point in exchange for the lower rate. Lenders view this as prepaid interest. Because they lose money on the lower interest rate they provide you, they make it up with the point. One point equals 1 percentage of the loan amount.
Origination points are fees lenders charge for “difficult” loans. They are commonly seen on stated income or alternative documentation loans. These loans generally pose a higher risk for lenders. They make up for the risk by collecting some of the profits up front. This way, if you default on your loan down the road, the lender made some money right away.
Paying points is a personal decision. In some cases, you do not have a choice, as is the case with many subprime loans. Lenders automatically include points in their quote. Conventional and government-backed loans often have a choice. You can choose the higher interest rate or pay the points for the lower rate. Looking at your long-term plans again will help you make the decision.
What is the Term?
Interest rates might speak volumes on their own, but looking at them in their true light helps more. You usually have the choice between terms when you apply for a mortgage. For example, a 15-year and 30-year term – each one has different interest rates. The 15-year will usually offer a lower rate, but a higher payment. The tradeoff, however, is you pay the loan off in half the time. This means you pay half of the interest charges. Depending on your loan amount, this could equal hundreds of thousands of dollars. Compare the payments between a 15 and 30-year term before making your decision. Sometimes the difference is a few hundred dollars. If you can afford the higher payment and qualify for it, consider taking it.
Do you owe Private Mortgage Insurance?
A down payment of less than 20% of the purchase price usually means you owe Private Mortgage Insurance. This can play a role in your total mortgage payment. It can even affect your interest rate. The less you put down on a home, the higher risk you pose. Lenders will not only charge PMI, but will increase the quoted interest rate. Look at your total mortgage payment, rather than focusing on the interest rate alone. This way you can see how it compares to your monthly income. Is it a payment you can easily afford? Over time, you may be able to cancel PMI, but you have to owe less than 80% of the home’s value first. This can take many years depending on how much you put down initially. Just like interest rates, PMI varies based on your credit and the amount you borrow. Looking at the full payment can help you make the right decision regarding your payment.
What can you Afford?
Honestly, this is the bottom line. The interest rate really does not matter if you cannot afford the payment. Look at the big picture. Figure out your total mortgage payment. This includes the principal, interest, real estate taxes, homeowner’s insurance, and mortgage insurance. Add these amounts up and see how they compare to the money you make. Divide the total mortgage payment by your gross monthly income. This gives you your front-end debt ratio. Keeping that ratio as low as possible makes it easier to afford. It also helps keep your interest rate down. 28% is a good rule to follow, although some loan programs do allow higher ratios. Only you know what you can afford. Whether the interest rate is as low as you wanted or not, it all comes down to the full payment.
It is tempting to focus on the interest rate alone, but that is not the only thing affecting your mortgage payment. Take a step back and look at everything. Consider your options including lowering your closing costs, paying points, and taking a shorter term. Figure out which option is the most affordable for you and then choose that option. Make the interest rate an afterthought. If you really want to focus on the rate, calculate the interest you would pay over the life of the loan. Then compare that amount to other loan options you have. This way you can minimize the interest you pay by choosing the right program rather than the lowest interest rate.