(Updated December 2014)
Securing a home mortgage is one of the largest financial transactions most consumers will ever make. But it doesn't have to be the most expensive. By following a few suggestions, you can make sure that your mortgage fits your budget.
Order your credit reports
Start off with your credit reports. Few things can jack up the interest rate on your loan like a low credit score. Order copies of your credit reports - one from each of the major credit reporting companies - and scrutinize them to make sure they provide an accurate picture of your credit history.
By federal law (The Fair Credit Reporting Act), you're entitled to a free copy of your credit report once a year from each of the three major reporting companies - Equifax, Experian and Transunion. Use the official web site established under Federal law for the purpose - www.AnnualCreditReport.com. There are other sites that will offer to provide your credit report for a fee or as part of a fee-based credit monitoring service, but AnnualCreditReport.com is the one that operates under the authority of the three firms.
If you find an inaccurate item that reflects negatively on your credit, you can complain directly to the credit reporting bureau that issued the report or take it up directly with the lender or business that submitted the information. If the negative item cannot be verified or if you can disprove it, it must be stricken from your report.
Check your credit score
While you're at it, you should also obtain your FICO credit score from at least one of the three companies. This will give you an idea of what sort of interest rate you can qualify for.
You want to be sure to get your FICO score and not one of the other types of credit scores that may be offered free of charge or even supplied with your free credit report - they aren't the same thing. The FICO score is the one lenders use when you apply for a loan, so that's the one you want to check.
Unlike your credit report, you'll usually have to pay to get your FICO score. However, some credit cards, such as Discover, have begun including an updated FICO score on their monthly billing statements, so check your cards to see if they provide this benefit.
The best interest rates go to borrowers with FICO scores of 760 and above; those from 700-759 pay about two-tenths of a percentage point more, and rates then go up in increments for every 20 point drop in your score from there. A borrower with a score in the 620 range will likely have to pay a rate 1.5 percentage points higher than someone with a 760+ score.
Because rates go up and down by steps, a small change in your credit score can sometimes make a significant difference in the rate you can get. That's where correcting errors on your credit report or reducing your overall debt load can really help. It's also why you want to avoid taking out new credit cards or other loans when you're planning to apply for a mortgage, because that can push your score down a few points.
Boost your down payment
Saving up for a down payment can be one of the most challenging parts of obtaining a mortgage. And most people don't have a lot of flexibility in regard to how much they can put down. But if it is possible to do so, increasing the size of your down payment can help you save money.
Just like with your credit score, the size of your down payment affects your interest rate. You may be able to get a loan with only 5 percent down, but you'll probably pay a higher rate than you would if you put down 10 percent, or 20 percent.
If you put down less than 20 percent on a mortgage, you'll have to pay for some sort of mortgage insurance for as long as you remain under 20 percent equity. The annual cost typically ranges from about 0.4 to 1.3 percent of your loan amount. Not only that, but the amount you pay varies according to how much you put down - you'll pay more for mortgage insurance if you put 5 percent down than if you put down 10 percent.
FHA loans allow you to make a down payment of as little as 3.5 percent, but the fees for mortgage insurance tend to be higher than those on loans backed by Fannie Mae or Freddie Mac. So if you can put a bit more down and get one of those, it may save you money over the long haul.
Shop around for lower prices. Variety is the spice of life. It can also save you money.
You have lots of options when shopping for a mortgage - banks, credit unions, brokers, online lenders, nonbank lenders and others. Each may have different advantages and disadvantages, and you won't know what's best for your situation until you check them out. Don't just go to your usual bank or financial institution and apply there - do some checking around.
Ideally, you want to get quotes from 4-5 different lenders before making a choice. That should give you a pretty good idea of what the going rates are for someone with your credit and will also give you some insight into the fees the different lenders charge, which can vary quite a bit. Which brings us to our next section.
Don't fixate on interest rates
Interest rates are the first thing most people look at when shopping for a mortgage. Lenders know this and so they try to structure their loans to offer an attractive rate. But a low rate can hide other fees than can actually make a home loan more costly than a competing offer with a higher rate.
All mortgages have closing costs, which typically run from 2 to 5 percent of the loan amount. While some lenders will offer mortgages that are advertised as having no closing costs, in reality all they're doing is charging a higher rate instead. On the other hand, other loan offers may come with higher closing costs added on in order to allow the lender to advertise a lower rate.
Trying to compare such offers to find the best deal can make your head spin, particularly if you're not very good at math. Fortunately, there's a simple way to cut through the clutter. It's called APR, or Annual Percentage Rate.
The APR on a mortgage basically expresses the total cost of the loan as an interest rate, as if all the closing costs were simply rolled into a higher rate, similar to what happens with "no-cost" loans. The lower the rate, the better. It isn't 100 percent accurate, but it's still a pretty good tool for comparing competing loan offers.
Consider buying points
Paying points may pay off. A point will cost you 1 percent of your total loan amount and lower your interest rate about one-eighth to one-quarter of a percent. This allows you to "buy down" or lower your interest rate.
Points are one of the main tools lenders use to advertise too-good-to-believe interest rates, which may be based on paying three-and-a-half points or more to get the rate that low. However, they can be useful as well. If you plan on owning the home for a fairly long time, the lower rate you get by buying points may pay for itself over the long term.
A mortgage calculator is a useful tool in this regard. It can allow you to see how long it would take for a lower interest rate to offset the cost of buying points and help you decide whether buying points would be worthwhile.
Don't overlook an ARM
Many people are leery of adjustable-rate mortgages (ARMs) these days, but they're a pretty good choice for certain buyers. If you expect to relocate or upgrade to a nicer home in a few years, an ARM can save you some money.
With an ARM, you can get an initial rate that's about a full percentage point lower than on a comparable 30-year fixed-rate mortgage. Of course, the interest rate on an ARM eventually adjusts to reflect current market, so you could end up paying a significantly higher rate five or 10 years down the road. But if you don't expect to be in the home longer than that, why pay more to lock in a rate for 30 years?
ARMs allow you to lock in the initial rate for anywhere from one to 10 years, with five- and seven-year locks the most popular. So they can be a very good choice for a starter home or for someone in a profession where they expect to relocate every few years.
Check out special programs
Depending on your personal situation, you might be able to qualify for a special loan program that can help you get a better rate, reduced fees or a lower down payment. Fannie Mae and Freddie Mac have unveiled new loan options that allow borrowers with modest incomes obtain mortgages with only 3 percent down. The Fannie Mae loan also has an option that allows qualified borrowers to avoid the increases in interest rates and mortgage insurance fees that are usually tacked onto loans with minimal down payments.
Another possibility is a USDA Rural Development Loan, which provides no-money down loans for qualified borrowers with modest incomes. While these must be used to buy a home in a "rural" location, in practice that means anywhere outside of an urban location, including many small towns and suburbs.
These specialty loan programs are not offered by every lender, so it may take some digging to find one who writes these loans in your area. But the savings can be considerable.