Taking the time to shop for a mortgage lender can pay off huge over 30 years in the form of interest savings. Let’s look at exactly how to shop for a mortgage lender to get the lowest rate.
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Know (and Improve) Your Credit Score
It doesn’t make sense to start shopping for a mortgage loan – or any type of loan or line of credit – without knowing where your credit stands. Generally, a higher score means a lower interest rate. You also have to meet certain minimum credit and income criteria to qualify for a mortgage loan at all. You can use Credit Karma to check your FICO score for free and without hurting your credit.
I delved into how to improve your credit score here. Try to lower your debt (specifically, your your debt-to-income ratio) and raise your score before shopping for a mortgage. Things like FICO score, debt-to-income ratio, payment history, and length of credit history are the primary credit factors that affect your mortgage rate. If you’ve very recently paid down a significant amount of debt, wait about 3 months to make sure your FICO score catches up (credit bureau reporting is slow) before you start applying for a mortgage.
Note that credit agencies can tell when a borrower is applying for a mortgage; multiple credit pulls within a 45-day period won’t hurt your score, so don’t worry about shopping around.
Clean Up Your Credit Report
Similarly, try to clean up any derogatory marks or incorrect entries on your credit report before starting the mortgage application process. I’ve had my identity stolen multiple times over the years. The first time I checked my credit report, it was littered with about 4 different sets of addresses and phone numbers that weren’t mine, along with credit cards that I didn’t open. These were unknowingly hurting my credit history and score and I had to spend some time, money, and effort getting them removed. Here’s how:
- Use Credit Karma to review your credit score and report. Look for any fraudulent information. Credit Karma can’t correct these entries for you, but it lets you view what the report from each credit bureau says.
- If you have any incorrect or fraudulent entries, you’ll have to edit them or file claims directly with each specific credit bureau, as different lenders pull reports and scores from different credit bureaus. In some instances this may require signing up for a premium paid account, even if only for a month.
- If you found a significant number of fraudulent entries or if you’re concerned that your sensitive information is out there for fraudsters to use, consider temporarily placing a freeze on your credit with each of the above bureaus and using a protective monitoring service like Norton Lifelock, which delivers cyber security, device protection, online privacy, and identity theft protection. Trust me; it’s much easier to preemptively prevent these types of invasions than to try to remove and correct them after the fact.
Types of Mortgages
Conventional mortgage loans come from private lenders like credit unions, commercial banks, and mortgage companies. They may or may not be guaranteed by federal agencies like Fannie Mae and Freddie Mac. Conventional loans may require a 20% downpayment.
Government-backed loans typically have smaller downpayment requirements and are suitable for borrowers with lower credit ratings and income levels. As such, these loans have special requirements such as primary residence (the property can’t be used as an investment or rental). These loans are backed by the VA (Veterans Affairs) for veterans, and/or the Federal Housing Administration (FHA) which are more popular among first-time homebuyers. You can still access government-backed mortgage loans through private lenders. VA loans usually require zero downpayment, and FHA loans require as little as 3.5%.
Jumbo loans are used in special cases where the borrower is attempting to finance more than about $400,000. As such, these loans have special restrictions, requirements, and characteristics.
Some private, conventional loans will also match the terms of a particular government-backed loan, e.g. a conventional loan with a low downpayment requirement designed for first-time homebuyers.
When shopping for a mortgage, lenders will clearly note whether the loan is a conventional or FHA (government) type.
Types of Mortgage Financing
There are two types of financing in regard to mortgage loans.
Fixed-rate mortgages are “plain vanilla” type with a fixed interest rate that doesn’t change over the life of the loan. This provides predictable payments.
Adjustable-rate mortgages (ARM), as the name implies, are loans wherein the interest rate changes in relation to the market rate. These loans are also referred to as “variable rate” or “floating rate.” The introductory interest rate may indeed be lower than a fixed-rate alternative, but it can – and likely will – increase drastically after the introductory period ends. ARMs are typically used by buyers who expect interest rates to decline or those who plan to pay off the loan before the interest rate changes happen.
I would argue a fixed-rate mortgage is more suitable for most homeowners. They are naturally considered “safer.” Note that you can always refinance a fixed-rate mortgage to take advantage of a decline in interest rates. When shopping for a mortgage, lenders will clearly note whether the loan is a fixed-rate or variable-rate type.
Downpayments, Private Mortgage Insurance, and LTV
An important part of the mortgage process is figuring out how much you can afford as a downpayment, the initial deposit required on a mortgage loan. Outside of VA (Veterans Administration) loans, this is usually at least 3.5% of the loan amount. Some lenders require 20%. The lender will require proof of the cash for this downpayment and where it came from.
If your downpayment is less than 20% of the loan value, you are required to purchase what’s called private mortgage insurance, or PMI. This protects the lender in the case that you, the borrower, fail to make payments.
Be sure to note the total cost of the PMI and how much it will affect your monthly payment. The cost of PMI is typically a not-insignificant portion of the loan payment, and it usually benefits you as the borrower to try to avoid PMI or pay down the loan as quickly as possible to get rid of it. The lender is required by law (the Homeowners’ Protection Act, to be exact) to remove PMI after your loan-to-value ratio, written as LTV, reaches 78%, without you having to ask. You can ask in writing that your PMI be removed after your LTV reaches 80%.
LTV is just your loan amount divided by your home’s value. For a simplistic example, if your loan balance is $140,000 and your home’s appraised value is also $150,000, your LTV is a little over 93%.
You will be required to pay PMI monthly until your LTV reaches 80%, with you asking for cancellation, or 78% without you having to ask. Unfortunately, mortgage loans are front-loaded where your initial payments are almost entirely interest and no principal, so reaching that 80% may take longer than you think.
The other way to word this is that with an 80% LTV, you have 20% equity in your home. If your home conveniently increases in value due to fluctuations in the local housing market, you now automatically, intrinsically have more equity, which may allow you to cancel PMI sooner. If you believe your home has risen in value significantly due to changes in the local market in recent years, or if you’ve recently done some remodeling, it may benefit you to have the home re-appraised to see if you qualify to get rid of that pesky PMI payment. Note that most lenders require at least 2 years of price change history to use this as a basis for PMI cancellation in regards to LTV, so approaching it from this side may be a bit more cumbersome.
The internal rate of return on paying down your loan to ditch PMI is usually even higher than the average expected return of investing in the stock market, so it’s typically sensible to aggressively attempt to get rid of PMI before investing by making extra payments toward your loan’s principal. For this reason, it’s advantageous to increase your downpayment as much as you can afford, up to 20%, to avoid PMI altogether. Be sure to ask your lender about any prepayment penalties and the ability to make extra principal payments.
After you’ve secured your mortgage loan and signed the paperwork, look into the specific terms and procedures of your lender’s PMI. They may, for example, require cancellation requests in writing, specific approved appraisers, etc. Lenders and the insurance companies providing their PMI may drag their feet, so have this paperwork ready to send as soon as your LTV hits the requisite amount.
Shop Multiple Mortgage Lenders for the Lowest Rate
Now it’s finally time to go shopping for the lowest rate!
Contact several types of institutions when shopping for a mortgage lender – apply with a commercial bank, a local credit union, and an online provider. You never know which provider will have the most suitable mortgage loan with the most favorable terms for your personal situation.
That last option – modern, online loan providers – are becoming increasingly popular, as they don’t have the overhead of a traditional physical bank and can pass those savings on to you in the form of lower fees and/or lower rates. You can check rates with Credit Karma.
Take note of the small details when comparison shopping for a mortgage lender. A mortgage loan is typically accompanied by a slew of fees – application, appraisal, origination, underwriting, broker, document prep, attorney, credit report, etc. When comparing two loan products, the one with the lower interest rate may have higher fees that end up making the loan more expensive than the one with the higher interest rate. Usually you can roll most of these fees into the loan itself if you prefer.
You can also negotiate with the lender to remove some of their fees, especially if you are a particularly high-creditworthiness individual, which gives you more bargaining power. Think of it like shopping for a car and negotiating with a salesman; same idea. Just like you can tell the car salesman that you just visited the dealership down the street, you can mention to one mortgage lender that another lender is giving you more favorable terms for the same loan product.
Some lenders have “no-fee” mortgage loan options, allowing for easier, quicker comparison; all things being equal, you want to look for the lowest rate. Just be sure to factor in any applicable fees so that you know you’re comparing apples to apples. A loan’s annual percentage rate (APR), expressed as a yearly rate, takes into account not only the interest rate but also any fees and “points” (next section).
Also obviously make sure you can afford the monthly payment of whatever loan you choose. A 15-year-term mortgage loan will likely have a lower interest rate than a 30-year loan, but will have a higher monthly payment.
Average interest rates fluctuate based on market conditions and can change daily, and online calculators may not be accurate. The Fed does not directly set mortgage interest rates. Lenders may also have promotions on certain mortgage loan products. Get quotes that are personal to you.
Don’t ignore the importance of customer service through this process; there can be a lot of paperwork and back-and-forth involved sometimes. Also make sure your lender’s communication allows email and digital document upload. You don’t want to be having to snail mail or make trips to drop off all the documents required throughout the process. Ask about your lender’s communication method(s), turnaround times, extraneous fees, etc.
At this point you might be feeling overwhelmed and that this is a daunting process. Just remember it’s worth it to put in the time and effort now rather than rushing through the process by applying to one single lender. A difference in interest rate of 0.25% may look small, but that difference results in thousands of dollars over the life of your loan. Not shopping around can be a costly mistake.
Consider Buying Down the Rate, Or Don’t
Borrowers can “buy down” the interest rate by paying for “points,” which are one-time up-front fees paid to the lender to drop the interest rate. One “point” is 1% of the loan value and reduces the interest rate by about 0.25%. For example, you may be able to pay $3,000 on a $300,000 loan to “buy down” the interest rate from 3% to 2.75%.
There’s a fine line for buying points to reduce the interest rate. The general rule of thumb is that it probably makes sense to buy down the rate if you plan to live in the home for at least 10 years. On the other end, a borrower who only plans to live in the home for 3 years before moving probably should not buy down their rate, as they won’t recoup the points paid in interest savings over the life of the loan.
The reality is that most borrowers severely overestimate the amount of time they will live in their new home before moving. Life happens; things change; a new career may mean a sudden move to a different city or state. Take that into consideration and don’t buy down your rate too much to the point where you can’t realistically expect to recoup the cost of the points in interest savings over the life of the loan.
Make sure points are being quoted to you in dollars. If your lender is helpful, they can calculate for you whether or not buying down your rate makes financial sense.
Get It in Writing and Consider a Lock-In
Once you’ve pinpointed a lender, product, and terms you’re satisfied with, get it in writing. You can optionally obtain a written “lock-in” that quite literally “locks in” the stated rate and terms for a specified time period. The lender may charge a fee for this lock-in document, but sometimes it is refundable at closing. The lock-in protects you from any rate increases while your loan is being processed. For example, a 4.5% interest rate may rise to 5% over the course of 1 week.
Separately, the lender can provide you with what’s called a preapproval letter that can give you an advantage when shopping for a home. This letter proves that a banking institution has already evaluated your financial situation, considers you worthy of a mortgage loan, and has determined the home value you can afford. All things being equal, in the eyes of a seller, a potential buyer with a preapproval letter in hand is considered more serious and more qualified.
A preapproval letter also expedites the mortgage process when you’re ready to make an offer, as the lender will already have your information on file ready to roll. Typically, a lender will require most or all of the following for preapproval:
- Financial account statements – checking, savings, investments, etc.
- Debt obligations – credit cards, auto loans, student loans, etc.
- 2 years of tax returns and W-2’s.
- 2 recent pay stubs.
- Salary and employer information.
- Detailed information about the downpayment, including its amount and its origin.
After submitting the actual mortgage application, the lender will be heavily involved and invested in your finances through closing. Don’t make any major purchases, rack up credit card debt, change jobs, etc. during this time period. Lenders will often recheck your credit report before closing.
This mortgage shopping worksheet may be useful in your journey.
Shopping for a mortgage lender doesn’t have to be insurmountable. Take the time and effort to do it right because your future self will thank you for all the interest savings. Using the worksheet linked above can make the process easier and keep you organized.
Disclaimer: While I love diving into investing-related data and playing around with backtests, I am in no way a certified expert. I have no formal financial education. I am not a financial advisor, portfolio manager, or accountant. This is not financial advice, investing advice, or tax advice. The information on this website is for informational and recreational purposes only. Investment products discussed (ETFs, mutual funds, etc.) are for illustrative purposes only. It is not a recommendation to buy, sell, or otherwise transact in any of the products mentioned. Do your own due diligence. Past performance does not guarantee future returns. Read my lengthier disclaimer here.