How can I be sure to get a good price on a mortgage?
One of the common mistakes made by homebuyers is not shopping around enough for a mortgage. Going with a single lender -- without doing comparison shopping -- is an invitation to get screwed. By pitting the lenders against one another you can gain amazing concessions that would not otherwise be available.
A recent example of this very truism happened to a couple Aaron and Naomi when they received a preapproval letter from a lender for a 30-year fixed loan. The interest rate they received kicked ass -- 6.1% with zero points! When they scrutinized the loan further, they discovered that the closing costs and prepaids added up to a whopping $10,000. Upon realizing this, Aaron and Noami were much less excited about their loan.
They then went to a second lender where they were offered a "No Fee" mortgage, which had zero closing costs. "Wow! Zero closing costs -- the deal of a lifetime, " the couple doubtfully hoped. Then the other hammer fell: the loan came with an outrageously bad 6.8% interest rate, which would wipe out all of their cost savings within months.
Luckily, and by accident, the couple had come prepared with a preapproval letter from the other lender. When they presented it to the loan officer, it had the desired effect -- she immediately dropped the interest rate on the loan to 6.125% with no closing costs. You can see how shopping around can be worth the extra time that it takes.
What kind of loan should I get? An ARM or fixed rate mortgage?
Besides being an appendage of the human body, an ARM is an Adjustable Rate Mortgage. This differs from a fixed rate mortgage because the interest rate floats freely with the market's interest rate. If market interest rates fall, the interest rate paid by the borrower also falls; if interest rates rise, then costs to the buyer rise in lockstep with market rates.
A fixed rate mortgage has the same interest rate for the lifetime of the loan. It doesn't matter what the happens to the market interest rates. The buyer is always paying the same interest rates, and -- as a result -- the monthly payments remain constant.
So is one type of loan better than the other? I'm going out on a limb any saying "yes." In most cases it is far better to get a fixed rate loan than an ARM.
As discussed above, fixed rate loans offer the same payment from month-to-month. If your monthly payment at the beginning of the loan is $1,200 it will remain at $1,200 for the lifetime of the mortgage. As a result, owners of fixed rate mortgages are able to better estimate their monthly costs because their mortgage payments never change. Inflation can even become your friend when you hold a fixed rate loan because the payment becomes less expensive over time as inflation eats away at the value of money.
Holders of Adjustable Rate Mortgages experience more of a roller-coaster ride: when rates fall, monthly payments plummet. When interest rates rise, monthly payments soar and the holder of an ARM gets raked over the coals. Thus inflation is the enemy of someone holding an Adjustable Rate Mortgage because it increases the monthly payments on the loan. This is true because rising inflation levels usually translate into rising interest rates on loans.
If you like fixed costs, peace of mind, and being able to sleep like a baby at night, get a fixed loan and purchase a house within your means. If, on the other hand, you want to take on some extra risk and really stretch your buying power, get an Adjustable Rate Mortgage. My preference is for a fixed rate mortgage.
What are points and should I buy them?
A point is a fee you pay to the lender in exchange for a lower interest rate. This fee is perhaps the single greatest ripoff you will encounter when purchasing a home. In the vast majority of situations it makes no sense to purchase points and you should always request a loan with zero points.
A point costs 1% of the total amount of your loan. So if you were borrowing $200,000, a point would cost you $2,000. How much does a point lower the cost of your loan? It depends, but usually purchasing a point will reduce the interest rate on your loan by 0.125%.
Why are points such a losing proposition? There are several reasons. First and foremost -- if interest rates fall, you can always refinance your loan. In this case, any points you have paid will be mostly wasted unless you have held the mortgage for a long time (typically 5 years or more.) Second -- for most buyers, the money spent on points is better spent elsewhere. Set aside the extra cash for a rainy day or use it to make home improvements.
Should anyone pay points? There is a small minority of homebuyers who should pay points. According to the IRS, points used to purchase a primary residence are tax deductible. You should always consultant an accountant, but if you need some extra tax deductions you may want to consider paying points. If you do elect to pay points, you should plan on holding the loan for a very long time. In a typical scenario, it might take 5 years or more to recoup the cost of paying points. You should consider whether you really want to lock yourself into a loan for this period of time.