Interest Rates Matter
I have a theory about this. My theory is that people either pay too little attention to the effect of the interest rate on their finances, or they focus too much on the interest rate and not enough on the terms.
- The people with high credit who come to my friend’s sub-prime lending company are making the first mistake.
- The man I know who lowered his nominal interest rate by refinancing with a negative amortization loan (he did not check the terms to see the real interest rate before signing off) are making the second mistake.
The middle course is to go through all the types of loans and the various important terms, as shown above, and determine what combination is best for you. You can comparison shop, making sure that every lender whom you talk to understands the terms you want and quotes based on those terms.
You should know this walking in:
- What sort of mortgage you want
- The number of years you want it to run
- The prepayment penalties you will accept
- Whether or not you want to pay biweekly
The above are items are just the beginning. Read these pages to be prepared for your conversation at the banks (talk to more than one), so that you can make apples to apples to comparisons and get the best possible deal.
The “APR” makes comparisons much easier.
When I got my first car loan I was shocked to find that different loans were calculated in different ways so that interest rates that appeared on paper to be lower than another rate might actually be higher! (This is usually done by ignoring the decline of principle as payments are made. They treat the loan as if the entire balance were outstanding during the whole period, when in fact principal is being paid down from the first day.)
Fortunately the government stepped in and created what is called “The Annual Percentage Rate” or “APR.” The government specifies the method for calculating the APR so the rate is consistent from one loan (or savings account) to another. Using the APR you can make true apples to apples comparisons.
Whenever anyone quotes you an interest rate ask them if it’s the APR. If they say no, pay no attention. Tell them you want to know the APR. They are required to give it to you.
In print, they can show a rate calculated in whatever way they want (negative amortization loans sell themselves by showing ridiculously low starter rates) but they must also show you the APR in type just as big as the rate they calculate their own way. Do not pay any attention to the other rate. It’s truly meaningless.
So, you give the possible lenders your list of conditions and ask them to tell you what the APR on their loan will be. Then (and only then) you can compare one loan to another with confidence. You may be willing to pay a slightly higher APR in return for some other advantage (like having a local bank or better prepayment penalties) but without some offsetting advantage like that you would be crazy to pay a higher APR for the same money you could get more cheaply elsewhere.
Don't dismiss an "ARM" until you've checked it out.
In most cases, the surest way to get a lower interest rate up front is to choose a one year "adjustable rate mortgage" or ARM. Because the lender can change the rate if Interest rates go up, they are willing to give you a lower starting rare, usually atleast one point below their 30-year rate (although this is not always the case).
Most people are afraid of ARM's because they don't want to take any risk at all. They hate the thought that the rate can go up, every year! They do not even take the time to do the math. A typical ARM changes rates every year, but even annual ARM's have restrictions on them. They usually cannot increase more than two points in one year or five points over the entire term of the loan. And they can also decrease by the same amount. So, the first thing to check is how bad it would be on your budget if the ARM went up by two points.
On a $100,000 mortgage, that would increase your monthly payment by about $130.
Would that break your budget? Remember that a two point increase is very unusual. One is a lot. The rate is based on some index, like the London Interbank Offer Rate or LIBOR (see above for details on that index) plus some amount, often one or one and a half percentage points. The LIBOR is not a wild and crazy index. It tends to track interest on US government bonds.
I got two mortgages within a year of one another, one on my first home and one on a second home. This was seven years ago. On one I got an ARM (at a local bank) but convinced that interest rates were going up, I got a fixed rate on the other.
At first, interest rates did not go up; they went down, and I was paying as little as 2.75% on my ARM and 6% on the fixed. Before I could refinance, interest rates came back up, but the ARM's rate is lagging, and I am still paying more than a point less on the ARM.
All in all, I have saved thousands of dollars on the ARM.
If you can't cope with an ARM, try a "fixed-step"
I call them combos myself, but they start out at a fixed rate for some period of time (anywhere from two to ten years) and then convert to an ARM. Often they convert to one-year ARM's, but they can also have longer periods between changes, up to three years or more. Some of these mortages are simply two fixed rates. They will go ten years at one fixed rate, after which it is reset, and the new rate applies to the entire remaining period.
These rates are never as low as ARM's but they are usually lower than fixed. Since most houses are sold in seven to ten years anyway, there is not a lot of risk of having monthly payments become unmanageable before you move on.
The big advantage of any kind of ARM is that if interest rates go down, your payments will go down automatically. You won't have to go through the hassle and expense (at least $5,000 in fees in most cases) of refinancing your mortgage to get a lower rate.
For the lenders, adjustable mortgages are a two-edged sword. They avoid being stuck with low interest loans, but when interest rates go down, they are much happier with fixed interest loans. The mortgage industry made most of its money from 2000 to 2005 replacing high fixed interest loans with low fixed interest loans. The fees are very rewarding!
Don't try to forecast interest rates.
Even the experts can't do that. The failure of economists to make accurate interest rate forecasts is regularly documented in the Wall Street Journal. Don't think you can do better. You can't. Make all decisions based on the assumption that interest rates can go in either direction, and probably will do both over time.
If you get a fixed rate mortgage make the term as short as possible.
Fixed rate mortgages are the most popular kind of mortgage because most people are afraid of higher interest rates. People are betting that interest rates will go up. The level of refinancing that has gone on in the last five years or so shows that things did not go as expected.
Only you can decide if you can tolerate the risk that your payments will increase, but if you decide to go with a fixed rate loan, make it as short as you can.
We have already shown that you can save more than $54,000 in interest per $100,000 borrowed by choosing a 20-year mortgage over a 30-year mortgage, assuming the same interest rate (6.25%). A 15-year mortgage will save even more.
Lenders will usually give you a lower interest rate on your mortgage if you do a shorter term. Switching from 30 years to 15 years could save you half a point. And it might not raise your payments as much as you think. For example, using the same interest rate(6.25%) the payment on $100,000n is $616 on a 30-year note, and $857 on a 20-year note. With a half-point drop in interest rate, that difference would be even less.
Recently some banks and sub-prime lenders have been offering 40-year terms on fixed mortgages. This comes close to an interest-only loan in the beginning. You don't want to do this if you can help it, unless you are pretty sure you can unilaterally raise your own payments at some point and reduce the actual term to below 30 years. If you run out the whole 40 years the total interest paid gets obscene.
Know your FICO score.
Now that we've covered everything else, we should turn at least some attention to what may be the single most important factor in the interest rate you are offered by lenders for your mortgage, no matter what kind it is. That is your "FICO" score. this is a credit score
produced by a company called "Fair Isaac." It is the most common credit score used by mortgage lenders to determine if you are a qualified borrower.
FICO scores range from 350 to 850. Even sub-prime lenders will be reluctant to give you a mortgage if your FICO score is under 500. Regular lenders usually want to see at least 600 on your FICO. The best rates go to people over 700. Over 800 is even better.
You can get your FICO score (or one just like it) by asking your lender to provide the score they used when they made an offer for a loan (or turned you down). You can also get it from the three credit agencies when you get your free annual credit report.
There is not much you can do about your FICO score in the short term, but if you have some time, you can probably raise it.
Here is what you have to do to improve your credit score:
1. Pay your bills on time.
The single most important factor in your credit score (but not the only important one) is your payment history. Missing payments, or paying the minimum due each time on credit cards, will lower your credit score, and it can take years of improved payment activity to increase it. If you have used debt management plans or filed bankruptcy, your score will be severely impacted for years.
One problem with this part of your score can be mistakes on your file. They are common. You are entitled to a free credit report from every credit reporting agency once a year. [Click here for info on how to get yours over the web]. You should collect these reports and check for errors. If you find any, go to our credit repair section [click here] for information on how to get it corrected. This can take a lot of time, but if you are in a hurry, you may be able to get your prospective lender to speed things alone so that your loan clears at the best possible rate.
2. Be careful about how you borrow.
The amount you owe is the other major component of any credit score. But it is not simply the total amount you owe that is taken into account. Most credit score algorithms look at whether or not your credit is “maxed out.” So if you have a line of credit on your home that is borrowed up to the maximum allowed, or you have borrowed all you can on your credit cards, then your score will be lower. It is better to have three credit cards with a credit limit of $2,000 each on which you have balances of $1,000 each than one credit card with a limit of $3,000 which is “maxed out.”
The next three items are not as important as the first two, but they should also be taken into account.
3. Be careful of too much credit activity.
Even inquiring about borrowing from different lenders can lower your score. (The credit reporting agencies record every inquiry made on your file.) If the agencies see a lot of activity, they deduct points from your credit score. Every time you open a new line of credit, your score is impacted -- at least temporarily. So, when the store you are in offers you a deal for signing up for a new credit card, do not do it unless the deal is really good -- or unless you do not care if your credit score goes down temporarily.
4. Maintain many different types of accounts.
If your only credit is in credit cards you will get a lower score. Lenders like to see someone with experience at handling different types of loans, like car loans, mortgage loans, and installment plans, as well as credit cards.
5. Live long and prosper.
The length of your credit history is also important. If you are one of those people who pays cash whenever they can and hates to borrow, your credit score will be lower. Having many different forms of credit in your history -- including multiple credit cards -- will (if managed without defaults), convince lenders that you are a sophisticated user of credit. In short, this will help them