If you want to get the best possible mortgage deal, it’s essential that you know how to shop for a mortgage the correct way. The vast majority of mortgage shoppers out there have no clue how mortgage pricing works. I don’t want you to be one of them! Ignorance makes it much easier for unscrupulous lenders to take advantage of you.
I’ve been a mortgage professional for over 11 years now. It’s my goal with this article to teach you to be a savvy mortgage shopper. I’ll first show you the little known secrets of how mortgage pricing works. Once I’ve done that, I’ll then teach you how to take advantage of your knowledge to get the best mortgage deal you can.
You with me? All right, let’s dig in!
There’s No Set Rate and Costs for Every Loan
Contrary to what many people believe, there’s no set rate and closing costs for a given loan product and/or mortgage borrower. Each loan product, whether it’s a 30-year fixed, 5/1 ARM, etc., has a range of rates and closing costs.
For example, let’s assume a lender’s 30-year fixed rate sheet has interest rates that range from 3.750% to 4.500%. The lower rate options typically will come with higher closing costs. The higher rate options will usually offer lower (or no) closing costs.
It works this way for a very simple reason: a mortgage with a lower rate accrues less interest than a mortgage with a higher rate. If you’re willing to go with a higher interest rate, there’s more money in the deal for the lender, which means they’re more able to cover all or part of your closing costs with a lender credit.
Figure 1 shows what the lender’s rate sheet might look like. You’ll notice that the lowest interest rates are at the top of the rate sheet. You also notice that price (the middle column) goes from negative to positive as you move down the rate sheet from lowest to highest rate.
A negative price indicates a cost, which means you’ll be paying more fees to get that interest rate. A positive price indicates a lender credit is available, which can be applied to closing costs.
Assuming you want the 3.750% interest rate, you’ll have to pay a 2.000 cost, which is 2% of the loan amount, or 2 “points”. If you’re borrowing $200,000, that’s an additional $4,000 in fees that would go on top of third party costs such as appraisal, title, escrow, etc.
On the other hand, if you opt for the 4.500% interest rate, you’ll receive a lender credit of 2.250, or 2 1/4 points. Again, assuming you’re borrowing $200,000, that’s a $4,500 lender credit that can be applied toward third party costs. If your third party costs are $4,500 or less, then you would have a “no cost” loan because the lender credit would cover everything.
No or Low Cost is Easier on Larger Loans
Third party costs (title, escrow, appraisal, credit report, etc.) tend to be fairly similar whether you’re borrowing $100,000 or $400,000. It doesn’t usually cost any more to appraise a $150,000 house than it does a $500,000 house. Because lender credit is a percentage of loan amount, it’s much easier to get a big lender credit and a really low rate if you have a large loan amount. For example, if you’re borrowing $100,000, a 1.000 lender credit is just $1,000. It’s a good bet that won’t cover all the third party costs to get the loan done. However, if you’re borrowing $400,000, a 1.000 lender credit is $4,000, which would likely cover all or very nearly all closing costs in many states.
If your loan is relatively small, expect to pay a higher rate and/or closing costs. It’s just a fact of life. If your loan amount is much larger, it’s possible to get some of the lowest rates on the market with little to no cost. Remember, larger loans accrue more interest, so it’s easier for lenders to cover most or all of the closing costs at lower interest rates than small loans.
Low Cost or Low Rate?
So, what’s better? Lower rate and higher cost, or higher rate and lower cost? Well, that depends on an important factor that very few mortgage shoppers take into account: time. In other words, how long do you think you’ll keep the loan? Obviously, nobody can predict the future with any real certainty, but if it’s a good bet you’ll keep the loan for at least 7 to 10 years, a lower rate/higher cost option might make more sense. If you know you’ll be selling the house and moving within the next 3 years, a higher rate/lower cost option probably makes more sense. Let me show you why.
Figure 2 shows the cumulative loan costs for each of the interest rate options at 3, 5, 7, and 12 years, taking into account closing costs and accrued interest. Note that we’re assuming the amount borrowed is $200,000 and the loan product is a 30-year fixed. Note also that all closing costs are being rolled into the new loan, which is typical for most refinance scenarios.
You’ll notice that the loan option with the lowest APR is the 3.75% rate – which, incidentally, also comes with the highest closing costs. That great low rate comes with a whopping $8,650 worth of fees that will be rolled into the new loan. This is why shopping by APR alone is not always a good idea!
After three years, the loan with the lowest cumulative costs is also the one with the highest interest rate. As crazy as it sounds, the highest rate loan is actually the cheapest overall if you only keep it for three years.
After five years, the 4.50% option is still the cheapest over all, but the 4.00% interest rate option is not far behind.
At seven years, the lower interest costs of the 4.00% rate has overtaken the 4.50% to become the cheapest loan.
At twelve years, the 3.75% has finally caught up to and surpassed it’s higher rate siblings. Because the up front costs were so much higher, it took more than a decade for the 3.75% loan to be a better deal than the other options. Wow!
As you can see, a mortgage is more than just an interest rate! You also have to look at closing costs and the amount of time you’re likely to have the loan before you can truly make an educated decision about which loan option is the best.
Hopefully you’ve also noticed that shopping based on APR is not necessarily a good idea, either! The lowest APR in this case also comes with the highest fees. If you select your loan based on APR only, you could end up paying much more for the loan than you have to if you don’t keep it long enough.
Most mortgage shoppers shop for rate and fees, but it’s also important to shop based on time. In other words, how long you plan to keep the loan. If you know you’re only going to keep the loan a few years, low or no cost could make sense. Or, if you know you’re going to keep the loan for at least ten years, you might consider paying more in fees to get a lower rate. For everybody else, the best strategy is usually a balance of both rate and fees. Don’t pay too much or too little for either.
How to Get an Awesome Mortgage Deal
Thanks for hanging with me this far! It’s important that you understand how mortgage pricing works before I can show you how to use it to your advantage. Now that you have a good foundation of knowledge, let’s get to where the rubber meets the road: how to get a great mortgage deal. I’ll teach you how to do that in part 2 of this article (click the link below).