When most people start shopping for a mortgage, the first thing they do is look for the lowest interest rate they can find. And that can get them into trouble.
A low interest rate can save you money, obviously. But it’s only part of the story. If you’re not careful, you could easily end up paying more in fees and other costs than you’re saving with the interest rate itself.
Here’s why. The interest rate is only part of what you pay for a mortgage. You also have to pay certain fees just for taking out the loan, which vary from lender to lender. A lender may charge higher fees to offset a lower interest rate, or may even pad a loan with “junk fees” to pad his or her profits.
Because these fees are often rolled into the loan itself — that is, you borrow the money to pay them, along with the actual mortgage — it can be difficult to be sure just how much you’ll end up paying versus another loan with a different interest rate and fee structure.
Here’s a closer look at some of the main reasons you don’t want to get fixated on interest rates when shopping for a mortgage.
Discount points are the most common way of lowering a mortgage rate by charging higher fees. Each point is equal to 1 percent of the loan amount. For each point you pay upfront, you get the interest rate lowered by a certain amount, often one-eighth of a percentage point — for example, from 3.75 percent to 3.625 percent.
On the one hand, discount points are a legitimate way of buying a lower interest rate by pre-paying a certain amount of interest up front. On the other, lenders sometimes use them to create artificially low rates, particularly for use in advertising, even if it’s unlikely that a borrower would buy that many points in the first place.
Discount points can be a good deal if you’re going to be in the home long enough for them to pay off. That is, long enough for your savings from the lower interest rate to exceed what you paid in points. But if you expect to move again or refinance the loan in a few years, they probably aren’t worth it.
Your best bet when shopping for a mortgage is to first get rate quotes without points when comparing offers from different lenders, then later inquire about adding discount points if you think you might be interested.
If you get a mortgage, you’re going to have to pay origination fees. There’s no way around it. Some mortgages may be advertised as “no fee,” but what they’re doing there is offsetting the cost of the fees by charging you a higher interest rate, which may or may not be a good deal.
Lenders may also charge higher fees simply as a way of offering a lower interest rate. Though discount points are the most straightforward way of doing this, lenders may also simply charge more in origination fees as well. They may also charge certain fees that other lenders don’t even charge. You may find that, even without points, there may be a difference of several thousand dollars in fees between what two lenders are charging for the same loan amount.
Again, since these fees are either paid for separately upfront or may be rolled into the mortgage itself, it can be difficult to tell what’s the best deal.
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A better way of comparing mortgage offers is to look at the Annual Percentage Rate, or APR. It’s a way of expressing the total cost of a mortgage in terms of an interest rate.
By law, the APR must be featured in any mortgage advertisement that describes loan terms and in the paperwork a lender gives you when making a formal loan offer and at closing.
The way APR works is that it’s basically the interest rate that would get you the same monthly payment on a loan with no fees as you’d pay on the same mortgage with the fees rolled into the loan amount.
For example, let’s say you’re borrowing $200,000 at 3.5 percent on a 30-year mortgage with $6,000 in fees. Rolling the fees into the loan gives you a total of $206,000, which at 3.5 percent produces a monthly payment of $925 (not including taxes and homeowner’s insurance) over 30 years.
To get that same monthly payment on a flat $200,000 without fees, you’d need an interest rate of 3.74 percent, which is your APR. In other words, the additional 0.24 percent represents the cost of your fees in terms of the loan.
Shortcomings of APR
APR is a helpful guide, but it’s not perfect. For one thing, it’s based on paying off the loan over the full term. If you refinance, sell the home or otherwise pay the loan off early, it changes the calculation. Remember, the less time you have the loan, the less benefit you get from a lower rate with higher fees.
APR also doesn’t take into account the impacts of tax deductions for mortgage interest, which can lessen the bite of a higher interest rate and varies significantly from borrower to borrower.
To really assess the difference between two mortgage offers, you need to use a mortgage calculator. These are readily available online and allow you to see exactly how the costs and savings of different loan offers will play out over time.