You have a steady job, a few bucks in your savings account and are thinking about purchasing your first home. You know you’ll need to apply for a mortgage, but how do you know you’re getting the best overall financing package? How do you know you’re getting the best deal when you buy anything; you shop around and compare pricing.
Over the years, we have had homebuyers who either don’t know to or are unwilling to shop their mortgage. At SBC Homes, we have partnered with a preferred lender who provides $3,500 for homebuyers who close their loan with them. However, just because our preferred lender offers some incentive cash to finance a mortgage, doesn’t mean they are the best overall financing package, which is why we encourage buyers to shop their mortgage.
What makes for a good financing package? Well to answer that question, we first need to look at the variables in a mortgage. Here are the key components to calculating a mortgage rate:
- Principal: Amount Financed (Purchase Price less any down payment)
- Term: Time, length of mortgage (typically 30-years or 360-monthly payments)
- Interest Rate: The percentage of an amount of money charged for use over a period of time, typically represented in interest per year.
These three variables are used to calculate the monthly payment, and by changing any of the variables, the monthly payment will change. For instance, if you took out a $200,000 mortgage at a 6.5% interest rate, with a 15-year term, your monthly payment, without property taxes and insurance would be $1,742.21. If you thought this monthly payment was too high, how could it be adjusted? Lowering the principal with a higher down payment would lower the monthly payment. Another way to get a lower payment would be to buy down the interest rate, if that option was available. The final option would be to increase the term from 15-years to 30-years. Of course, one could also look to adjust any combination of the variables to reduce the monthly payment, but the easiest, no additional cash option would be to adjust the term. Adjusting the term from 15-years to 30-years, doubles the amount of time to pay off the mortgage, and reduces the monthly payment from $1,742/mo. to $1,264/mo. The downside of this strategy is that you will end up paying significantly more total interest if the mortgage is carried to term.
Ok, so now you understand the variables of calculating a mortgage payment, but how do you assess a financing package? To answer this question let’s take an example from Bankrate.com. By selecting the “Home Purchase” option on the home page, you can enter the zip code, purchase price, down payment amount, assumed credit score, and the loan term to search for mortgages being offered in your area. In the search that I performed I was given several mortgage options, along with options to buy down the base rate. I am going to assess two of the mortgage options to illustrate why you need to shop your mortgage and consider all fees, before signing on the dotted line.
Mortgage Company #1 advertised a base rate (meaning before paying any points) of 6.804%, with an option to buy down the rate to 5.99%. The points needed to buy down the rate were 1.907 points at a cost of $7,212. As an aside, the cost of points is calculated as a percentage of the financed amount. In my example, the financed amount (purchase price less down payment) was $378,203, so the cost of 1.907 points is ($378,203 x 0.01907 = $7,212). Mortgage Company #1 is charging almost 2 points to buy the rate down by 0.814 percentage points, or less than 1 percent. Additionally, Mortgage Company #1 requires Private Mortgage Insurance (PMI) at a cost of $248/mo., thereby bringing the monthly mortgage payment, before property taxes and property insurance to $2,514/mo.
Let’s compare Mortgage Company #1 to Mortgage Company #2. Mortgage Company #2 is offering a base rate of 6.331% with an option to buy the rate down to 6.125%. At first glance while the base rate is less than Mortgage Company #1, the rate after points is higher than Mortgage Company #1, so you would think the monthly payment would be higher from Mortgage Company #2. However, the monthly payment is less. Mortgage Company #2 shows the monthly payment as $2,297/mo., roughly $217 less than Mortgage Company #1. How is this possible? Mortgage Company #1, while having the better interest rate is charging PMI on top of the monthly payment, so the end monthly cost is higher than the loan from Mortgage Company #2, with a higher interest rate.
| Principal | Interest Rate (no buy down) | Interest Rate (with buy down) | Cost of Points | Mo. Payment | PMI | Total | |
| Mortgage Co. #1 | $378,203 | 6.804% | 5.99% | $7,212 | $2,265 | $248 | $2,514 |
| Mortgage Co. #2 | $378,203 | 6.331% | 6.119% | $6,376 | $2,297 | $0 | $2,297 |
The summary chart above illustrates how important it is to evaluate the finance package. Mortgage Company #1 is charging almost $900 more to buy down the base rate and is saddling the loan with an additional $248/mo. of PMI, making the upfront costs and the monthly costs more expensive than Mortgage Company #2, with a higher interest rate. The lowest interest rate does not always equal the lowest monthly payment. Be sure to read the fine print and ask a lot of questions. As the message on my childhood cartoon intermission read… “the more you know…”