As homebuyers, we all want to save money. We look for the best price on a home, and try to find the most affordable mortgage, which often means focusing on the lowest possible interest rate.
This makes perfect sense, as low interest rates can save you tens of thousands of dollars over the life of a loan.
But an interest rate is not the only factor. As mortgage borrowers, we need to look beyond the interest rate and consider the total costs of a loan. By accounting for closing costs, APR, PMI, and other factors, you’ll better understand the total cost for using a mortgage on your purchase.
March Myth: Lowest Interest Rate is Always the Best Option
This myth, like many myths in the real estate industry, is rooted in reality. Essentially, the myth holds that the interest rate on your loan is the most important factor, possibly the only factor, that you should consider when looking for a mortgage.
The interest rate matters, as the difference in just a single percentage point can equal tens of thousands of dollars across the life of your loan. Interest rate is easily one of the most important factors in your mortgage, but this importance has been inflated to levels that over-emphasize its value. Basically, it’s too often seen as the only factor that matters.
Interest rates matter, but the thought that a loan with a low interest rate is always the best option is, in reality, a myth.
Fact: Look at your TOTAL costs, Including Closing Costs, APR, and Mortgage Insurance
While interest rates matter, the reality is that you need to consider more than just interest when looking at your loan. You need to consider the total costs, which includes closing costs, mortgage insurance (PMI), and origination fees. And of course, there is the all-important annual percentage rate (APR), which is a better representation of your total loan costs.
Understanding Annual Percentage Rate
Interest rate is important, but to understand the total costs of your loan, you need to focus on the annual percentage rate, commonly called the “APR.”
APR includes not only the interest rate, but the fees and other costs that are involved in the loan. These include broker fees, closing costs, rebates, and discount points that have been purchased by the borrower. The total of these costs is usually expressed as a percentage and becomes the “APR.”
Note: The APR should be greater than the interest rate because it includes the interest as well as other costs. In some cases, it may be equal to the interest rate, but it is almost never less than the interest rate.
APR is calculated by finding the total cost of the mortgage loan’s upfront fees, then spreading them across the life of the loan to estimate the annual costs. This cost is added to the interest rate to find the real cost of financing your home’s purchase. Essentially, it indicates the true amount you will pay for your mortgage.
APR is not perfect, but it is better, as far as estimating the total cost of purchasing a home with a mortgage, than interest rates. According to law, APR must be listed on mortgage documents, and the estimation for APR must include interest, points, origination fees, broker fees, and mortgage insurance.
Some costs, however, cannot or typically are not included. Notary fees, home appraisals, and attorney fees are usually not part of the APR calculation.
When Might a Higher Interest Rate Be a Good Trade Off?
Let us be clear: when all other factors are the same, a low interest rate is the best. Also, in most cases a low interest rate is best. But there are certain situations when you may want to consider trading a lower interest rate for other advantages on the loan. We won’t crunch the specific numbers for each scenario (that could fill a dictionary and would be anything but interesting), but we will outline some general times when a higher interest rate may be acceptable.
A Low Down Payment
One of the situations where you may consider a higher interest rate is if you can secure the loan with a low down payment. Essentially, the larger the down payment you can bring, the lower your potential interest rate (Again, this is a general statement, not a guarantee). But some feel that instead of using money for a down payment, a better strategy is to go with a low down payment, accept the higher monthly payment and potential interest, and invest the remaining cash. The returns on the investment, it’s believed, are worth the higher mortgage payments.
This strategy, of course, requires attention to detail and a bit of investment luck. You are never guaranteed that an investment return will compensate for the higher costs, but some may prefer this strategy.
A Higher Rate with Low Closing Costs
Closing costs vary by lender, so it’s entirely possible for one lender to offer small closing costs while another charges high fees to close the loan. If one lender is offering low interest rates, but their closing costs are significantly higher than the competition, it may actually cost more to use their lending services.
A Higher Rate But No Mortgage Insurance (or No Removable Insurance)
Mortgage insurance can cost about a $100 a month in some cases, which means you will have an added cost to your loan (A cost that is, by the way, not reflected by the interest rate). However, some low-rate loans may have mortgage insurance not just at the beginning of your mortgage, but through the entire life of the loan.
This can mean significant expenses overall and could equal tens of thousands of dollars from the point of taking out the loan to finally closing the mortgage.
All of these factors need to be considered, which is why it’s so important to work with a lending team that is dedicated to providing not just great loans, but the information and guidance you need.
Find the Service You Need on the Loan You Deserve!
Remember, interest rate is important, but it’s not the only thing that should be considered!
Contact our staff and let us help you understand mortgage costs, interest rate, APR, and other factors.