One of the most frustrating aspects of boning up on how to buy a home – especially for the first-time homebuyer – is the lack of clear information. Articles all over the Internet claim that the homebuyer should “shop around for the best mortgage.”
If this is your first time trying to obtain a mortgage, how are you supposed to know what to look for when you “shop around?” A little more information in these articles would go a long way in helping the newbie wrap his or her head around the process, right?
Help is right here, my friend. Let’s take a walk down the mortgage shopping aisles and get you out the door with the cheapest, most attractive mortgage known to man or woman. Before we do that, however, realize that interest rates are but one aspect you should consider when comparing lender offerings.
Mortgage rates are determined by several factors:
- Credit score
- What’s happening in the financial markets
- The particular loan program you choose
As you can see, you have little control over the last two. The first – your credit score – is completely under your control. When interest rates overall are low and you choose a program that holds those rates low, the only thing holding you back from getting a super low rate is your credit.
Let’s assume, then, that you are pre-approved for a mortgage. The lender will “lock-in” your rate at that time, for a specific period, typically 30 days. After that the rate may go up.
Annual Percentage Rate (APR)
The APR is the yearly cost of a mortgage, including interest, mortgage insurance, and any points paid. The word “points,” by the way, is the lender’s way of saying “fees.” Each point is based on one percent of the loan amount.
The APR is expressed as a percentage and can be higher than the interest rate your lender quoted you. The APR is important in that is represents the true annual cost of the loan program. It is useful when comparing different loan products and options.
Fixed Rate Mortgage vs. Adjustable Rate Mortgage
A fixed-rate mortgage is quite straightforward. The mortgage rate is constant for the duration of the loan. Monthly payments are a set amount and remain at that amount until the loan is paid off. These mortgages are normally amortized (paid off) over a 15-, 20- or 30-year period.
Instead of being locked-in for the entire term of the loan as with a fixed-rate mortgage, monthly payments on an adjustable rate mortgage (ARM) can change quarterly or annually, fluctuating in relation to changes in the financial market. Initially, ARM rates are lower than those of fixed rate mortgages, allowing buyers to qualify for larger loans. ARMs are risky in that the interest rate may go up substantially instead of down.
The terms used to describe an adjustable rate mortgage and its conditions are unfamiliar to most homebuyers. Let’s take a look at some of the more frequently used terms.
Adjustment Period: Rates for an ARM are adjusted at set times, such as once a year. A 5/1 ARM, for instance, has a fixed rate for the first five years and then adjusts annually.
Payment Caps: Caps refer to how high or low your interest payments can be and are expressed in three numbers, such as 2/2/6. The first number signifies how much the interest rate may adjust at the first adjustment point. In this case it would be no more than 2 percent. The second number is how much the rate may adjust at every adjustment point after the first. In the case of our example, the rate could go up or down no more than 2 percent. Finally, the third number represents the highest the rate can ever go over the life of the loan. Again, using the example above, a 2/2/6 cap means that your loan’s interest rate can adjust no more or less than 6 percent.
Fully Indexed Rate: Adjustable rate mortgages are based on one of many publicly published financial indicators, the U.S. 30-year bond index for instance. These indicators are combined with a predetermined margin that sets maximum and minimum changes to produce your interest payment for the period. Therefore, if the index was set at 6.5 percent, and your mortgage margin was 2.1 percent, your fully indexed rate (the amount you pay) would be 8.6 percent.
Negative Amortization: It is possible for adjustments and payment caps to result in monthly payments that do not cover the interest you are being charged. If this is the case, the unpaid interest is added back into your principal.
Adjustable rate mortgages can be beneficial if interest is low, but many homebuyers are leery - and rightfully so - of the idea that larger monthly payments may also occur. A convertible ARM offers a compromise. At certain points throughout the loan, the mortgage can be converted into a fixed-rate mortgage, locking in an interest rate.
Remember, interest rates are only one item to compare when shopping for a mortgage.