February 6th, 2015 12:38 PM by Jackie A. Graves, President
When a lender loans
you money to buy a home, it expects to make money for the service. It
does this by charging interest on the loan. The higher the interest rate,
the higher your monthly payments and the higher the loan’s total cost.
Figuring out the best interest rate for your mortgage can be tricky, but it’s
not impossible. Here’s a rundown of how it works.
Adjustable or fixed
You need to consider
whether the interest rate you are quoted will remain the same for the life of
the loan (known as a fixed-rate
mortgage, or FRM) or change over time (known as an adjustable-rate mortgage, or ARM).
Adjustable rates will
typically start out lower than fixed rates during an introductory period before
adjusting to a higher rate. How many times the rate can adjust depends on the
loan—it might happen once a year.
Because it’s hard to
predict which way interest rates will go over the long term, there’s some risk involved
with an adjustable rate. However, if you don’t want to keep the home for a long
time, the low introductory rates for ARMs can be beneficial. Those who plan to
see out the life of their loan may prefer an FRM.
Margin and index
An interest rate is
made up of two parts: the margin and the index. The margin is the lender’s
profit margin, which can vary from lender to lender and may be negotiable. The index is a rate set
by economic factors.
With an ARM, the
margin stays fixed but the index fluctuates. With an FRM, both stay fixed.
You can lower your
rate by buying discount points at closing. Buying one point typically equals
knocking 0.25% off the interest rate. One point costs 1% of the total loan
amount. So if you buy one point off a $200,000 loan with a 3.5% interest rate,
you pay $2,000 for a reduced interest rate of 3.25%.
Before doing this,
know how many months it will take you to recoup what you
paid for the point. If it’s going to take six years to break even
but you plan to sell in five, you’ll lose money.
Some lenders may offer
you a slightly lower interest rate for a prepayment penalty agreement. The
prepayment penalty is what it sounds like: If you pay off your mortgage too
early, you have to pay a hefty fee.
If the prepayment
penalty period is short, say, within a few years, and you don’t plan on
refinancing or selling, it’s probably worth it. But if you’re looking at a
penalty period that stretches longer into the loan’s life, it’s probably not
Get multiple quotes
If you want to find
the best rate, you’ll need to know what competing lenders are offering. Get
several quotes from different lenders. Make sure you get the good-faith estimate for each offer so
that you can compare them.
Locking in or floating
If you’re going with
an FRM or a mortgage with a fixed-rate period (like a hybrid ARM), you have to
decide when to lock in the interest rate. When you do, the lender guarantees
the rate for a certain number of days. The longer the guarantee period, the more it
You can also
go for a float-down option, which allows you to get a lower interest rate
if rates go down. The terms, conditions, and costs of this option vary from
lender to lender.
By: Craig Donofrio | Updated
from an earlier version by Laura Sherman
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