Why Trying to Get the Lowest Possible Mortgage Rate Could Backfire

Don't assume a lower rate is always a better bet.

If you are thinking about taking out a home loan, chances are you've been told that you need to shop around and compare rates and terms before committing to a mortgage. And this is indeed good advice, as you don't want to get stuck with a loan that's more expensive than it needs to be.

As you shop around for a mortgage, your primary focus will probably be on the rate you're offered. Since interest is the cost of borrowing, it's understandable why you would believe that a lower rate will make your loan more affordable. 

The only problem is, there's more to your loan than just the financing charge. And in some cases, trying to get the lowest rate could cost you. Here's why.

A lower rate doesn't necessarily mean your mortgage will be the cheapest over time

One of the biggest reasons why trying to get the lowest rate possible could backfire is because a low rate does not always mean your loan will be the cheapest over time. 

See, there's a specific type of mortgage called an adjustable-rate mortgage or ARM. ARMs are an alternative to fixed-rate mortgages. As the names of each of these loans suggest, ARMs have adjustable rates and fixed-rate mortgages have fixed ones. With an ARM, your rate can change after an initial introductory period. With a fixed-rate loan, it will remain the same over the entire life of the loan. 

The problem is, ARMs generally have lower starting rates than fixed-rate loans. So if you're shopping around and looking only at interest rates, the ARM will seem cheaper. But it may not end up that way. If the financial index your rate is tied to goes up, then your rate will rise and the loan could end up being a lot more expensive in the long run than the fixed-rate loan would have been.

That's why it's so important to not just look at the interest rate that you start out with, but also whether your rate can be modified during the payoff period. If it can change, you are taking on a lot more risk and that might not be a good thing to do with your home on the line. 

Loans with lower rates can also lead to higher monthly payments and big opportunity costs

There's another situation where a quest for a low mortgage rate could create issues. This time, you could run into trouble if you choose a loan with a shorter payoff time, such as a 15-year loan instead of a 30-year one.

When it comes to your mortgage, the shorter the loan term, the lower the rate in most cases. But, when you cut time off your repayment schedule, your monthly payment goes higher even if your rate is lower. As a result, when you opt for a short payoff time, your total costs and interest rate will be lower but your monthly payments will be higher.

Higher monthly payments could make qualifying for the mortgage in the first place harder. And there's an opportunity cost, since you're tying up a lot more money in your home and making large payments to a low-interest loan with money that you could possibly be doing other things with. 

Like with the ARM, this example shows why you should look at all the details before you commit to borrow. If a loan with a lower interest rate presents more risk or could make your monthly payments unaffordable, you'd likely be better off paying a higher rate for a mortgage that you're confident you'll be able to comfortably pay over the life of the loan.