In a NutshellYou can't control every part of your mortgage, but you may be able to score a great interest rate by improving your credit and saving for a big down payment.
When you apply for a mortgage, there’s one factor that could save you tens of thousands of dollars if you play it right: your interest rate.
Your interest rate impacts how much you’ll pay your lender over time. Fortunately, you may be able to influence the interest rate you get by taking steps to build your credit, saving for a big down payment and researching your options.
Mortgage experts predict that interest rates will jump by a half percentage point this year, which may seem trivial. But take a closer look: A 30-year, $250,000 mortgage with a 4.25 percent fixed interest rate will cost about $21,400 less over the life of the loan than the same mortgage with a 4.75 percent rate.
By being proactive about prepping your finances and researching the best mortgage rate, you can save big time.
Whether you’re planning on refinancing your current abode or purchasing a new home, here’s what you can do to better your chances of scoring a great mortgage rate:
Right now, an interest rate around 4 percent is considered good, says Tim Milauskas, a loan officer at First Home Mortgage in Millersville, Maryland.
When you shop for mortgages, the rates you’re offered will be driven mostly by your credit, Milauskas says. You can check your credit with Credit Karma for free, though keep in mind that these are educational scores – mortgage lenders will likely use a different score.
If your score needs work or your report has errors on it, take steps now to build your credit before applying for a mortgage. If you’re able to boost your credit, you could save a lot in interest.
“Generally, a 100-point increase can save a buyer tremendously,” Milauskas says. “For instance, the difference between a 660 and 760 credit score could save anywhere from 0.5 to 1 percent on a rate.”
Two of the biggest factors that contribute to your credit scores are whether you consistently pay on time and how much debt you owe.
If you’ve missed a few payments on your credit cards or loans in the last year, focus on paying your bills on time this year. “Mortgage lenders are usually interested in several months’ [worth] of timely payments,” Milauskas says.
Next, pay down your debt if you have extra cash. Aaron Morse, mortgage loan officer at Affinity Federal Credit Union in Oradell, New Jersey, recommends a strategy called the “debt snowball,” which involves paying off your smallest debt first (while making the minimum payments on your other accounts) and then using the money you would have used for that payment to pay extra on your next-smallest debt, and so on. This way you free up more immediate money in your budget and your credit could improve.
If you have extra cash available, Morse says that taking out a personal loan could add a different type of loan to your credit mix, which could further improve your credit if you don’t already have a personal loan. He suggests using your cash reserves to make on-time payments on the personal loan, which may boost your credit scores.
When taking out a mortgage, you’ll pay a certain percentage of the home’s value upfront. This is called a down payment.
While you may be approved for a mortgage with a down payment of less than 20 percent (FHA loans allow for down payments as low as 3.5 percent, for example), a down payment of less than 20 percent is typically considered more risky to lenders.
On the other hand, a down payment of 20 percent or more could help improve your mortgage rate by an eighth of a percentage point to as much as half a percent, says Milauskas. It can also help you avoid having to pay for private mortgage insurance (PMI), which protects the lender if you stop making your mortgage payments. Borrowers are typically required to pay for PMI when they get a loan with a down payment that’s less than 20 percent.
It can be hard to save for a 20 percent down payment, especially if you’re trying to pay down debt at the same time. After all, a 20 percent down payment on a $250,000 house is $50,000 — not an amount everyone can easily set aside. If you have the time and availability, you might consider getting a side job to help you save.
In any case, Morse cautions that you should carefully consider your overall financial situation before shelling out a large down payment. Lenders generally require that you have at least two months’ worth of cash reserves in your savings account.
“If putting 20 percent down is going to take all of your assets, I usually recommend against that,” Morse says. “Cash in the bank is going to be very valuable compared to equity in the house. We all have those rainy days when the car breaks down and the house needs a new roof. It could be better to keep that money aside.”
Mortgage loans typically come in two forms:
- Conventional loans are not insured or guaranteed by a government agency.
- Government-insured loans are backed by a government agency such as the Federal Housing Administration (FHA) or Veterans Administration (VA).
Generally, people with lower credit and smaller down payments can qualify for an FHA loan, but they tend to be more expensive than conventional loans. Your loan officer can help determine what type of loan you qualify for and what’s best for your situation.
Rates also typically come in two types:
- Fixed-rate loans lock in your interest rate for the entire loan term, which often range from 10 to 30 years.
- Adjustable-rate loans typically have a fixed interest rate for five, seven or 10 years and then adjust annually after that (based on an index).
Although you may qualify for a low adjustable rate — they’re typically lower than fixed rates by about 1 percentage point — it may increase over time.
The most popular type of adjustable-rate mortgage (ARM) is the 5/1, where your rate is fixed for five years and then adjusts every year after that. But if you know you’ll be in the home more than five years, it may make more sense to get the fixed rate, which starts a bit higher than the ARM but won’t increase.
You may be able to improve that fixed rate with discount points, which are fees you can pay the lender at closing in exchange for a reduced interest rate. One point costs 1 percent of the mortgage amount, so if you’re borrowing $160,000 on a 30-year mortgage, then you’ll pay $1,600. One point could lower your rate by about 0.25 percent.
If you have the money for points, determine whether you’ll be in the home long enough to recoup that upfront fee, says Milauskas. On that $160,000 mortgage, if you buy two points and save 0.50 percent on your rate, then it’ll take you about three years to recoup the cost.
Your finances are in order, and you know what type of loan you want. Now it’s time to shop around for a mortgage.
“This is likely going to be the biggest purchase of your life — it’s not a bad idea to go to two or three financial institutions,” Morse says. Rates can fluctuate daily and even from hour to hour, he adds, so take that into account while shopping. You might want to shop on different days to get a mix of options.
Start with your bank or credit union, as they may offer you a better rate simply for having an existing banking relationship with them. Make sure you’re also checking other credit unions, national banks, and local or regional banks.
From one lender to the next, you may see different promotional rates, fees, interest rates and offers for discount points. For example, Morse says his credit union doesn’t charge an application fee, which saves about $500. Fortunately, lenders must provide you with a standard Loan Estimate, which makes it easier for you to compare loans.
Heads up: Shopping for a mortgage will add a hard inquiry to your credit reports, which may temporarily lower your scores. Try to limit your shopping to a 45-day window, as multiple credit inquiries from mortgage lenders within this time frame may be treated as just one.
You can help influence your mortgage interest rate by putting in some work first. If you build your credit, save for a down payment, choose the right type of mortgage and rate for your situation, and shop around for the best rates, you can have some say in your mortgage payment.
Armed with this information, take a look at your financial situation and determine what you want and create a plan of action to get there. If your credit and savings are in good shape, take the next step and start shopping for mortgage rates.
Calculate your PMI
Get an idea of how much private mortgage insurance you may have to pay if you get a mortgage.