After 16 years in the Seattle real estate market it’s frustrating to see how easy it still is for home buyers to be led in the wrong direction (or sometimes to wander that way on their own) when trying to get the best deal on a home loan. I’m a real estate agent, not a financial or lending expert, but based on my clients’ experiences here are a few tips that I’ve found are extremely useful to know when shopping for a mortgage.
Comparing Loan Programs and Lenders
1. Get quotes on the same day. Interest rates change daily, so by doing this all of the lenders you talk with will have access to the same interest rate. (Getting two to three quotes is common.)
2. Get estimates in writing. It will just be an estimate until you decide to go with that lender, identify a property, and lock in a rate, but estimates in writing are always better.
3. Compare fixed costs not set by the lender, such as the escrow and title fees. A lender who anticipates realistic amounts for these fees may appear more expensive than one who underestimates them.
4. Compare prepaid expenses, such as future insurance and taxes paid up front and held by the lender. Depending on the lender or program, you may be quoted as needing to bring in only two months worth of prepaids, or it could be six months. Again, the loan with six months of prepaids is not necessarily the most expensive loan (since you have to pay insurance and taxes no matter what) but it might look more expensive in terms of the initial cash you need to bring in to closing.
Comparing Rates and Discount Points
The cost of a home loan is a function of the interest rate and the cost of closing the loan. Discount points can be paid at closing in order to reduce the interest rate. A discount point is 1% of the loan amount, and one point typically reduces the interest rate by around .25%, although this varies.
So, how would a buyer compare a 30-year mortgage that has a 4.50 percent rate and no discount points with a mortgage that has a 3.875 percent rate and 2.50 points paid at closing? (Tip: The answer is not necessarily “by comparing the APR”.) In fact, unless you have Stephen Hawking on speed dial, this can be extremely complicated. However, there is a way to go about it that makes it simpler:
5. Ask for quotes at a specific interest rate, then compare costs. Since the two variables affecting the expense of the loan are rate and cost (and cost includes discount points paid at closing), by holding one variable constant you can easily compare the other to see which lender is offering a better deal. The easiest variable to hold constant when obtaining estimates is interest rate.
Note: Just remember Tips #3 and #4 above to make sure your cost comparison is not being skewed by any of the lenders underestimating the fixed costs or by a difference in the number of months of prepaid expenses due at closing.
Deciding Whether Or Not to Pay Points
As I explained above, you can pay discount points at closing in order to reduce the interest rate of the loan. In my opinion, there are two very important things to consider first.
6) Make sure any discount points will have time to pay for themselves.
For example: A buyer taking out a $300,000 mortgage could take a rate of 4.5% with no points and pay $1520 per month, or could pay 2 points at closing to bring the rate down to 4% and pay $1432 per month. Since the buyer paid an additional $6,000 (2 percent of $300,000) to reduce the monthly payment by $88 per month, they need to carry the loan for 68 months (6,000 divided by 88) in order to break even. If the buyer sells or refinances before the 68th month it would have been cheaper to not pay the 2 points.
7) Don’t put yourself in a precarious position just to buy down the rate.
If there’s any chance that something like a major car repair or a family emergency that involves travel and/or time off of work could endanger your ability to make a mortgage payment, then it may not be a good idea to part with a few thousand dollars in order to reduce your monthly payment by a relatively small amount.
Note: The same concept applies to putting additional funds into a down payment. I sometimes see buyers who don’t have huge reserves putting themselves under financial stress by squeezing any extra cash into the down payment, just because they’ve been told it’s always the most responsible thing to do. In reality, every additional $10K reduces the monthly payment by approximately less than $50. I completely understand the importance of building up home equity, but it’s worth also keeping in mind that when people lose their homes to foreclosure it’s usually not because they were lacking $50 per month, it’s because something bad happened unexpectedly and the cash reserves to weather it were not there.
Why Is APR Not the Easy Answer?
Annual Percentage Rate, or APR, is supposed to make comparing loans easier because it’s a percentage rate that takes into account both the interest rate of the loan and the cost of obtaining the loan. However, using APR as an evaluator is not always straightforward.
Loans with discount points will almost always have lower APRs, but as we noted above in Tip #6, discount points are not cost-effective for every buyer. The problem is that APR spreads the cost of the loan over its entire term, i.e. 30 years for a 30-year mortgage. If a buyer plans to pay off the loan early by selling, refinancing, or simply paying off the balance, then APR loses value as a comparison tool. Therefore…
8) Many experts counsel home buyers to rely more on Tip #5 than on APR when comparing loan programs.
9) Choose your mortgage professional carefully.
I’ve seen home buyers have a scary experience with a mortgage person who was recommended highly by their own friends. Also, keep in mind that some real estate agents choose their “preferred lender” based on whether or not that person can shuttle business to them, seeing as loan officers who work for big banks where people already have checking and savings accounts often get walk-in business from home buyers who don’t have an agent yet. A good real estate agent will potentially forego referral business by recommending lenders based solely on their merits.
The tips above will, I hope, come in handy when evaluating any lender and loan program.
(I am not a financial professional and this is not meant as expert financial or tax advice. Please consult with a qualified expert regarding any home loan.)