November 19, 2021
Buying a home is the biggest purchase most of us will make in our lifetime. That can make home hunting pretty intimidating. Even when you've found the perfect property, there's still the matter of getting a mortgage. For many people — particularly first-time homebuyers — home loans can seem confusing, full of financial jargon and numbers that seem to come out of nowhere.
But once you understand the terminology, those numbers start to make sense. Let's cut through the jargon to find out just what your mortgage actually costs.
Where does my mortgage rate come from?
Your mortgage rate determines the amount of interest you'll pay on the mortgage for the life of the loan. Over the life of a typical 30-year loan, the interest cost can be substantial. That means the lower the rate, the less interest you'll pay. Even a fraction of a percentage point less can make a big difference.
But a mortgage rate isn't a set number that's the same for everyone all the time. It changes based on the economy, your current financial situation, and a whole host of factors, including:
- Mortgage type – There are different types of mortgages with various rates.
- Your credit – Better credit can mean a lower rate.
- How much you're borrowing – Borrowing less can mean a lower rate.
- The length of the loan – A shorter-term usually has a lower interest rate.
Your rate also depends on whether you’re:
- Getting an adjustable-rate or fixed-rate mortgage. Adjustable rates are usually lower, but the rate is subject to change at preset intervals throughout the life of the loan.
- Paying up-front for points to lower your rate (more on this in a minute).
- Getting premium pricing, which reduces your out-of-pocket costs in exchange for a higher interest rate.
While some of these factors — like the economy — can't be changed, your mortgage rate can vary greatly based on multiple factors when you choose to buy or refinance a home. There's a tradeoff for every choice. So, you just have to decide which options make the most sense for your finances.
Home Loan Types
Conventional loans have good rates for those with excellent credit. Before applying for a mortgage, it’s always smart to review your credit report to see if there are any errors to fix.
What is a rate lock?
Because mortgage rates can change — even day-to-day — it's important to jump on a good rate when you see it. That's what a rate lock is all about. When you get an offer from a lender, you can typically "lock" it for anywhere from 30 to 60 days. That way, you know exactly what you'll pay if you close on a home within that timeframe.
Once you've looked at your mortgage options and have found a home, locking in a rate is usually as simple as talking to your lender about the offer you want. Ideally, you want to time your lock so you can close on a home during that period. Most homebuyers will lock in a rate after they've found their dream home. But if you don't manage to close by the end of your lock period your lender may be willing to extend the lock — but there may be a fee.
With prices fluctuating, the cost of waiting to lock in a rate could be significant. Instead of waiting (in which time - rates may rise), lock in a good deal as soon as it's within range of your closing date.
What is the difference between interest rate and APR?
When you're comparing mortgages, you may think the interest rate is all you have to worry about. But APR (annual percentage rate), while it may seem similar to interest rate, is also a key piece of the mortgage puzzle.
Your mortgage rate (or just interest rate) is an easy-to-understand number. It determines the amount of interest you'll pay on the loan. The APR is usually a bit higher than the interest rate because it includes the cost of some of your other mortgage-related expenses. These include broker fees and discount points. (But the APR may not include all fees, so be sure to ask your lender to find out.) That makes APR a more accurate measure of the total cost of your loan.
What are discount points and lender credits?
If you have plenty of savings, you may prefer to shell out a little extra today to avoid higher costs over time. But, if you're putting all of your spare funds into a down payment, you may not have much left to cover your mortgage closing costs. That's where points and lender credits come into play by letting you decide how — and when — to pay.
For an up-front fee, you can buy down your rate. These are called discount points. Each point equals 1% of the total loan amount — which will lower the interest rate on your loan. Typically, one point lowers the rate by .25% for the life of the loan. Please note, this can vary by lender.
Here's an example.
The cost of 1 point on a $300,000 loan is $3,000. If you pay $3,000, your rate could be lower by .25% for the life of the loan. So, if you were quoted a rate of 3.5%, if you paid for 1 point - your rate could go down to 3.25%. Essentially you are prepaying your interest to get a lower rate for the life of the loan.
That, in turn, will lower your monthly payments as well as the total amount of interest you'll pay over the life of the loan. If you have the cash on hand and expect to stay in the home for a long time, it usually makes sense to buy discount points.
The alternative is premium pricing – also called lender credits. In exchange for accepting a higher interest rate, the lender gives you a credit to use to help pay for your closing costs. While taking a slightly higher interest rate raises your cost over the life of the loan, it might not raise your monthly payments substantially. That can make premium pricing an ideal way to get into a home if you don't have a lot of cash on hand.
Along with shopping for a great rate, keep in mind that you also need to work with a trusted lender that can close on time. Now that you know more about how your interest rate is calculated, you're one step closer to getting the home loan you need.
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