For most Americans, a mortgage will be the biggest liability they ever incur. Yet, few people know enough about the market for home loans to determine whether they're getting a good deal or not -- and in many cases, they're not.
This is why I surveyed a handful of respected lenders and mortgage brokers on ways prospective borrowers can save money on their next mortgages. What follows, in turn, are the five best pieces of advice they offered.
1. Maintain a high credit score
Most people know that a better credit score makes it easier to get a mortgage, as a low score is one of the five most common reasons mortgage applications are denied. What fewer borrowers appreciate, however, is that a high score will also reduce the cost of the mortgage itself.
"For conventional loans, this means 740 or higher, as the middle of the three scores," says Matt Hodges of Presidential Mortgage Group in Charlottesville, Va. "When a credit score is in 20-point increments lower than 740, the loan is more likely to incur late payments or default. Agencies are compensated for that risk by increasing the cost through either points, a higher rate, or both."
How do you do this? Hodges advises prospective borrowers to "pay down car and student loans, and keep credit card balances at 35% or less of their respective limits." Additionally, as Bob Van Gilder of Finance One Mortgage told me, "don't allow multiple credit pulls during the application process, because these can lower your FICO score."
Click here to see four more common reasons mortgage applications get denied.
2. Put at least 5% down (though 20% is preferable)
Just as a higher credit score reduces the cost of a mortgage, so too does a higher down payment. But exactly how this works is more nuanced.
First of all, in an ideal world, the money for the down payment should be yours -- meaning, that you both earned it and can prove that you did so. "Let's not get a 'gift' from Aunt Sally if it's avoidable," says Van Gilder.
Lenders are looking for borrowers that are financially sound and mature enough to pay back their debts. As the chief executive officer of M&T Bank puts it, "the only good loan is one that gets paid back." One way to prove this is to have saved up your down payment.
It's also better to put more money down rather than less. At a minimum, you should be prepared to pay 5% in order to qualify for an FHA mortgage.
The downside to a payment of this size, however, is that you'll be required to pay private-label mortgage insurance, the current premium being equal to 1.35% of the mortgage, says Hodges. In addition, the FHA also charges an up-front cost of 1.75% that's added to the loan. The net result is that you are both borrowing more and repaying more over the life of the loan.
The way to avoid this is to put 20% down. This qualifies you for a conforming mortgage backed by Fannie Mae or Freddie Mac and thus avoids the necessity to get separate mortgage insurance altogether.
Click here to see a list of the five things you should know about mortgages, but probably don't.
3. Plan B in the event of a low down payment
Let's say you can't get 5% together but are nevertheless dead-set on buying a home, what are your options?
In this case, Hodges advises borrowers to consider a USDA Rural Development loan. "The upfront and annual costs are lower than an FHA mortgage, though the property must be in a 'rural' area, as defined by the USDA," he explained.
What about if you can put 5% down, but still come up short of 20%? In this case, as I discussed above, you'll be obligated to pay private-label mortgage insurance. But there's an alternative option to a conventional policy.
"You can pay PMI monthly, or buy it outright, with a single lump sum payment at close," James Adair of PDX Home Loan told me. "You can also get the lender or the seller to pay it for you if you're smart. Come in with a smaller down payment, get a low-cost PMI policy, and apply the cash to other debts, or invest if applicable. This is a seriously cheap, tax-advantaged debt attached to an appreciating asset!"
While I'd advise anyone to think long and hard about using debt like this to fund an investment portfolio, as well as assuming that home values will necessarily appreciate in real terms over the long run, it's nevertheless hard to deny that Adair's approach offers a creative alternative to the conventional private-label mortgage insurance.
Click here for a list of five things homebuyers should know, but probably don't.
4. Crush your fees
While residential mortgages have largely been commoditized thanks to Fannie Mae and Freddie Mac, there are certain elements that nevertheless vary and are negotiable.
"Rates and fees vary by broker based on their individual compensation agreements with the funding lender," says Van Gilder. Prospective borrowers should accordingly shop around before settling on a specific lender -- be it a bank or a mortgage broker.
It's also important to remember that the cost of a mortgage is the sum total of both the rate and fees. "People get really hung up on the rate, but the fees are a huge line item in a mortgage transaction," says Adair. In some cases, "the loan with the higher rate and low or no fees is often the less expensive loan."
Click here for a list of the five most common mistakes that homebuyers make.
5. Get an ARM
Adjustable-rate mortgages got a bad rap during the financial crisis thanks to unscrupulous mortgage brokers that pushed unwitting borrowers into them. And to a certain extent, homeowners would be wise to be wary of them. But as Adair told me, "they can be much more efficient than a conventional mortgage in many instances."
The problem wasn't with the mortgage product itself; it was rather that the product didn't suit the customer. It's like going to Starbucks for the first time and being advised to order a caramel macchiato when you're lactose intolerant and should be getting a soy latte. Even a perfectly prepared caramel macchiato won't do in this case. And it's the same with an ARM.
For borrowers that are willing to trade future uncertainty for current savings, there's a lot to be said about a five-year ARM. At Wells Fargo (NYSE:WFC), the current interest rate on a 30-year fixed-rate mortgage is 4.375% -- which, it's worth noting, is still cheap by historical standards. Meanwhile, the rate on a five-year ARM is 3% flat.