Every week, I see home buyers make the same expensive mistake: they simply don’t shop around for a mortgage.
It’s a shame. When you buy a home, getting the right mortgage loan is just as important as the right house. After all, you’re going to make this payment for every month in the imaginable future. For better or worse, the interest rate you lock in and type of loan you choose will have an impact on your financial future.
My advice? Consider all of your mortgage loan options before making a decision. Here’s a quick guide to seven things to understand when shopping for a mortgage:
1. The Stages of a Mortgage Application
Pre-qualification: Before you even go house shopping, you can get a mortgage pre-qualification letter. Just call a bank and answer a few questions about your income, assets and debts, and the kind of house you’re looking at. The bank will write you a letter telling your Realtor and any prospective sellers that you should be able to afford a mortgage up to a certain amount. Having a prequal does not mean you’re approved for a mortgage; they’re informal and optional, but they just might ease sellers’ fears that financing will fall through if they accept your offer.
Pre-approval: After you’ve put an offer on a home, you can get mortgage pre-approval. You’ll need to submit a mortgage application and the bank will run your credit and research the home you want to buy. If everything checks out, they’ll give you preapproval, which means, if all the conditions are met, the bank agrees to finance the home and you can march forward towards closing.
Confused? Read more on differences between pre-approval and pre-qualification.
Closing: Where it all comes together. Assuming everything is in order, this is where the mortgage is finalized and you become a home owner.
2. Loan Type
There are four common types of institutional mortgage loans: conventional, FHA, VA, and jumbo mortgages. Your first step in shopping for a mortgage loan should be to research which type of loans you qualify for and which would be best for your personal situation first. Each type of loan has benefits and drawbacks.
VA Loans: Guaranteed by the Department of Veterans Affairs, VA mortgages require as little as no down payment, but they are only available to qualified veterans.
FHA Loans: Backed by the Federal Housing Administration, FHA Loans require as little as 3.5% down if you (and the property you’re buying) qualify. This can be very helpful for those without a lot of cash reserves. But the drawback to putting less than 20% down payment is that you will be required to pay private mortgage insurance (PMI), a monthly payment used for security in case of default.
Conventional Loans: These mortgages require at least 20% down and don’t require PMI. Typically, a conventional loan is your best bet if you have enough money in your savings account to cover the down payment and associated closing costs.
Jumbo Mortgages: These loans must be used if you are financing more than conventional conforming loan limits (in most parts of the U.S., $417,000 in 2010). Due to their amount, these loans have special restrictions and credit requirements.
3. Repayment Terms
When choosing among the different types of home loans, you also need to consider the repayment terms. You can choose from a fixed interest rate, where the interest rate remains the same over the life of the loan, or an adjustable interest rate (ARM), where the interest rate can decrease or increase at specific intervals such as annually.
Fixed-Rate Mortgages: Fixed-rate loans are typically safer for families who plan on staying in the home for more than a few years. Many people choose mortgage loans with a repayment term of 30 years. But if you can afford to make higher monthly payments, you can actually get a 25, 20 or even a 15 year mortgage. The benefit of a shorter-term mortgage loan is that you end up saving money in the long run, since you pay less in interest.
Adjustable Rate Mortgages: Adjustable interest rate (ARM) mortgages can save you a lot of money if you play on living in the residence a short time. Your interest rate is much lower than a fixed-rate mortgage for the first five or seven years, but will then adjusts to the average interest rate ever year thereafter, which could be much higher. If you still own the home, your mortgage payment could go up dramatically, but it’s a risk some buyers take to enjoy a really low rate for several years.
4. Interest Rates
Getting the best interest rate is a key part of obtaining an affordable mortgage.
Check out the latest mortgage interest rates before calling mortgage lenders. This way you will know what to expect. If the national interest rate average is around 4.5% in the morning and a particular lender offers you 5%, you know you have room to negotiate. The closer a lender is to the national daily average, the less profit he is taking and the better deal you are getting. Get quotes from at least four different lenders either by phone or online. Be sure to compare rates on the same type of loan.
Ask lenders you speak with about how many points you will have to pay to obtain the specific interest rate. Mortgage points are pre-paid interest. One point equals 1% of the loan amount. The more points you pay up front, the lower your loan’s interest rate.
6. Annual Percentage Rate (APR)
Wait, isn’t an APR the same thing as the interest rate? People often use these terms interchangeably, but the APR is something very specific.
The APR shows the true cost of obtaining a loan, including points, the interest rate, broker fees and any other charges. The lower the yearly APR is the better deal you are getting. With the type of loan, interest rate, repayment terms and APR in consideration, you can sit down and make the choice about which loan is best.
7. Locking in Your Rate
Once you find a mortgage loan that you are happy with and receive preapproval, ask the lender to lock in the interest rate and provide you with a document in writing that states the interest rate you locked in, the amount of points you must pay, and how long the interest rate will be locked in before the offer expires.
Locking in an interest rate means that even if interest rates rise within the specific time that you were guaranteed, you can still option a mortgage loan for the lower rate that you locked in. The only drawback is that if you lock in an interest rate, for example, 5% and rates drop to 4.5% the next week, you could be stuck with the higher rate if you choose to obtain a loan from the specific lender. Locking in an interest rate is still a generally wise idea if you are serious about purchasing a home soon.
Where to Go From Here
There are a lot of ways to begin shopping for mortgages. You may know an independent mortgage broker you want to use, or you may just pick up the phone and begin calling local banks and credit unions. You can also try an online service like LendingTree to get up to four mortgage loan quotes online instantly.
Whichever route(s) you choose, remember that it’s often a good idea to try more than one, and that in the early stages of shopping for a mortgage loan, you’re under no obligation to move forward. As you go, try not to become overwhelmed with the many details and options in home loans. A bit of time and research will pay off in big savings for many years to come!