Mortgages: It’s NOT all about the monthly payment
If you’re in the market for a home and actively comparing offers, you’re off to the right start. Those who shop around tend to snag the largest lifetime savings, according to LendingTree’s Mortgage Rate Competition Index.
For many borrowers, shopping around translates to simply comparing whatever monthly payment each lender brings to the table — which, at first glance, makes sense. But any homeowner can tell you that your monthly payment makes up just one part of the overall cost of a mortgage. The truth is that there are a lot of moving parts to consider, and they all affect how much you’ll ultimately spend on a home purchase.
Looking beyond the monthly mortgage payment
Before we unpack the main factors that determine the cost of a mortgage, let’s first dive into what you should really be looking at when comparing lenders.
The APR. According to Tendayi Kapfidze, LendingTree’s chief economist, the most important thing to zero in on is the annual percentage rate (APR).
“It’s about more than just the interest rate, which really only refers to how much the lender is charging you to borrow that money,” Kapfidze told LendingTree. “If you want the lowest-cost loan, compare the APR because it includes all the other additional costs that come with taking on a mortgage.”
The interest rate is expressed as a charged percentage of the principal loan amount that’s tacked onto your monthly payment of the principal loan amount. The APR, on the other hand, provides a much more comprehensive idea of what your mortgage will ultimately cost you over the long haul because it also accounts for things like:
- Discount points: You can purchase these at closing to reduce your mortgage rate and lower your monthly payment. You’ll pay more upfront, but buying down your rate like this could save you money over the long term because your mortgage will essentially be cheaper. (We’ll break down the details shortly.)
- Origination fees: These are fees a mortgage lender throws in for originating your home loan. They cover things like processing, documenting, underwriting, etc. Origination fees can be presented as a percentage of the loan amount or as a flat fee.
- Mortgage insurance: This is a policy that protects the mortgage lender on the off chance that you fail to make good on your loan payments. While it isn’t mandatory across all loans, it is customary for homebuyers with a down payment that’s less than 20%. The good news is that once you hit the 20% equity mark, mortgage insurance is no longer necessary.
If you have an escrow account: This is an account, held by the lender, that a homebuyer pays into every month to cover insurance payments and property taxes. Then the lender pays these bills on their behalf. Some lenders might dangle a lower interest rate if you opt for an escrow account, but canceling the account later down the road could result in a fee.
Whether or not you have to pay mortgage tax: Also known as mortgage recording tax, this isn’t the same as your property taxes or mortgage rate. Instead, it’s a state-imposed tax that you’ll only have to pay if you live in Alabama, Florida, Minnesota, New York, Oklahoma, Tennessee, Virginia or Washington D.C. How much you’ll pay varies from state to state.
If there’s a prepayment penalty: This is exactly what it sounds like. If you’re planning on paying off your home loan sooner rather than later, it could cost you if your mortgage comes with a prepayment penalty. The charge varies, but may be presented as a percentage of the outstanding loan amount or the equivalent of a specific number of months’ interest.
Time in the home. In most cases, how long you plan on staying in the home is just as important as the interest rate itself. Why? Kapfidze says that a lower interest rate could come with higher upfront fees. The only way to save money in the long run is to keep the mortgage long enough to recoup those expenses.
Put it another way: If you end up refinancing your mortgage or moving sooner rather than later, those fees are spread out over a shorter period of time — essentially negating any savings because you might end up spending more than if you’d gone with a loan with a higher interest rate.
What factors can change the overall cost of your mortgage?
Your credit score and debt-to-income ratio. This one’s a biggie as the best interest rates generally go to those who have the best credit scores. A less-than-perfect score may also mean paying a higher premium for mortgage insurance. At the end of the day, these little details could end up costing you thousands of dollars over the life of your loan — even with a reasonable monthly payment.
Let’s say you’re taking out a 30-year fixed rate loan for $225,000. As you can see below, that loan gets more and more expensive the lower your credit score is, despite comparable monthly payments.
|Loan Cost by Credit Score|
|Credit Score||APR||Monthly Payment||Total Interest Paid|
*Calculated using the MyFico Loan Savings Calculator. Rates current as of Aug. 3, 2018.
You can expect lenders to pore over your credit report, where everything is pretty black and white. Delinquent accounts, derogatory remarks, late payments — they’ll all drag your score down. If a low score will ultimately cost you more than you’re comfortable paying, you might be better off pushing pause on your house hunt while you improve your credit score.
Your outstanding debt versus your total available debt, which makes up 30% of your credit score, also comes into the picture since it could put you in a lower credit range — leading to a more expensive loan. The big thing lenders look at is how much of your income is being spent on debt payments; something known as your debt-to-income (DTI) ratio. It matters because lenders want to see that you’ll easily be able to make your mortgage payments. To determine your DTI, add up your monthly debt payments, then divide that number by your gross monthly income. Keeping the final number at or below 36% is ideal.
Jerry Anderson, vice president of residential lending at Alliant Credit Union, says that while some lenders may be able to approve you with a DTI of up to 50%, you have to ask yourself if your budget is really able to absorb a new mortgage payment.
“What you qualify for may be very different from what you’re actually comfortable paying,” he told LendingTree. “It’s more about what actually fits into your budget.”
Your down payment. Putting less than 20% down may mean paying private mortgage insurance (PMI) is in your future. Let’s assume you have good credit and put 10% down on a $250,000 house. You have a 30-year fixed mortgage with a 4.6% rate. Plugging the numbers into our mortgage payment calculator, we see that you’ll be on the hook for a little over $117 per month for PMI. That’s an annual spend of over $1,400 that you’ll continue paying until you’ve acquired 20% equity in the property.
After throwing in the closing costs, escrow, attorney fees and the like, it’s easy to see how a lower down payment generally translates to a more expensive loan.
“Some states, for example, have a mortgage tax that has to be paid by the buyer, so be sure to look at all the closing fees, plus any state or local tax you’ll be responsible for,” said Anderson.
When comparing quotes from different lenders, look beyond the monthly payment and zoom in on any additional costs you’ll incur with each lender. You might notice, for instance, that one lender charges a prepayment penalty while another one doesn’t.
Fluctuating rates. Interest rates are on the rise, and they can also vary from lender to lender. Every financial institution is different, adhering to company-specific business strategies, profit margins, operating costs and so on. It can be frustrating to be drawn to a lender’s advertised low rates, only to find out that you don’t actually qualify, but take heart in knowing that lenders are indeed vying for your business. As such, there’s almost always room for negotiation.
One downside, of course, is that rates are ever-changing. “Good or bad, rates do change daily, sometimes multiple times per day, depending on the market,” said Anderson.
When shopping around, see if any lenders offer a rate lock period. This is exactly what it sounds like: a period of time where your interest rate is locked in while you prepare to close on the loan. Since rates fluctuate so much, a lender that offers a longer lock period may be more attractive.
Prepaid property taxes. When moving forward with a home purchase, the borrower usually gets a prorated credit to cover a chunk of their property taxes. Before closing, however, they may have to come up with a few months’ worth of property taxes and deposit it into their escrow account, just to protect themselves should their taxes increase in the coming year.
Exactly how much you’ll need depends on where you live. Anderson says that two identical homes in neighboring towns that have the same purchase price can have wildly different property taxes — everything from school districts to local economic activity play a role, and they can majorly increase the cost of your mortgage.
“You can lock in your loan for 30 years, but you can’t lock in your taxes for 30 years,” said Anderson. “And the way they move is that they always go up.”
Discount points. While shopping around and comparing quotes from different lenders, there’s another way to land a better interest rate. At closing, the borrower can purchase something called discount points, which reduces your rate and, in turn, your monthly payment. Each individual point works out to 1% of the loan amount. So two points on a $200,000 mortgage would add an additional $4,000 to your upfront costs.
Going this route is commonly referred to as “buying down” your mortgage rate. Pulling the trigger with discount points means paying more at the starting line, but if you plan on staying in the home for a long time, you’ll ultimately save money when all is said and done. If you’re taking a long view, and you have the money to spare upfront, it’s a tactic that could indeed make for a more cost-effective mortgage.
Bottom line: How to properly compare mortgage payments
Your monthly payment isn’t the be-all and end-all of your home loan, or a particularly good indicator of how much your mortgage will ultimately cost you. With that said, once you have a few lenders competing for your business, take a close look at the monthly payment they’re quoting you. Does it include things like property taxes, homeowners insurance, PMI and HOA dues, or is it merely the principal amount with interest tacked on?
Again, when it comes to estimating your loan, it’s all about looking at the big picture. The journey begins with first being clear on how much home you can reasonably afford, after which you can easily get a number of quotes before going through the preapproval process. LendingTree’s loan comparison tool quickly matches borrowers with multiple lenders. From there, it’s about engaging the ones that are offering the best rates and terms.