Everyone wants to save money. Especially on something like a mortgage or home purchase, where the size of the transaction means the potential savings can be considerable.
Lenders know this, so they offer a variety of money-saving inducements to get you in the door and sign on the dotted line with them. However, mortgages can be fairly complicated financial arrangements, which can make it hard to tell if certain "bargains" are really saving you money or not.
Many times, they won't be. In other cases, the answer will be...it depends. Whether you save money or not from a certain arrangement will depend on your particular circumstances. Something that will be a good deal and save money for one borrower may not work out so well for another.
Here are some of the more common mortgage "bargains" that look good on the surface, but may end up costing you money over the long run.
Wow. A loan with no costs. Or to be more precise, no closing costs. What could possibly go wrong here?
Plenty. Although this type of arrangement is very popular and works quite well for many people, you want to understand just how it works before you jump in.
In a no- or reduced-cost loan, the lender waives or pays some or all of the closing costs for you, in exchange for charging you a somewhat higher interest rate. Basically, the lender is fronting you the closing costs and will earn it back through the higher rate charge on the loan.
This isn't a bad deal, particularly if you have limited funds to bring to the table at closing. Many people would prefer a slightly higher monthly payment over the years rather than having to put up several thousand dollars right now.
However, that convenience comes with a price. Lenders are willing to do this because that slightly higher interest rate will more than pay for the closing costs in just a few years. And if you keep the home and don't refinance the mortgage until the loan is paid off, 15-30 years down the road, it becomes very profitable. Meanwhile, the lender may require a prepayment penalty if you choose to pay off the loan in 3-5 years, to insure their costs will still be covered.
A similar way to do this is by rolling the closing costs into the mortgage itself - that is, borrowing money for the closing costs as part of the loan. So your interest rate stays the same, but the loan amount is greater. That isn't exactly a no-cost loan, since you're borrowing the closing costs, but the principle is similar.
What! A low rate is a bad deal? How can that be? Isn't a low rate supposed to be the goal of every mortgage borrower?
Yes, it is. However, a low rate can sometimes hide high closing costs and fees. It's just the opposite of what happens with a "no-cost," loan, above - instead of raising the rate to get rid of the fees, they raise the fees to advertise a low rate.
If you come across an advertised rate that's noticeably lower than what other lenders are offering, it's a pretty good bet there are some hefty fees piled on there. To be sure, sometimes those extra fees are worth it to get a lower rate, but sometimes they aren't - what you need to do is compare what your mortgage payments and costs will be over time and figure out which is the best deal.
Something that is helpful in this regard is the APR, or annual percentage rate. This expresses the total cost of the loan, both interest rate and fees, in terms of an interest rate, and is a reasonably good rule-of-thumb as to how two loan offers measure up. It can't account for eventual rate adjustments on an ARM, though.
One of the main ways lenders offset a low rate by charging higher fees is by including discount points, sometimes called points for sure. These are a way of buying down your interest rate by prepaying some of the interest. Each discount point costs 1 percent of the loan amount and will usually reduce your interest rate by one-eighth to one-quarter of a percent.
Again, discount points can be a pretty good deal - there's a reason they're so popular. But they only work if you have the loan long enough for your savings in interest to offset the cost of the points themselves. If you think you might move in a few years, or refinance the loan, buying points might not be worth it. You need to run the numbers and see how long it will take to reach the break-even point to see if they make sense for you.
You don't see these very often, but they are out there. For people who are concerned about being able to make their monthly mortgage payment, stretching out the loan to 40 years instead of just 30 sounds like a reasonable solution. After all, you're extending the term by a full one-third, right? That ought to shrink the monthly payment a fair amount.
In reality, you don't get much of a payment reduction by going to 40 years instead of 30. Part of that is because of the way compound interest works - you're making interest payments over a longer period of time - and because a 40-year rate will be higher than a 30-year rate. You may find that going to a 40-year term, at today's rates, will only reduce your monthly payment by about 10 percent.
Most of the time, unless you're looking to refinance and need to reduce your payments as low as absolutely possible, you're better off with a 30-year loan.
ARMs can be useful mortgage products. But again, that's only if you're the right kind of borrower.
On most ARMs, the interest rate is fixed for the first few years, then it begins to readjust based on current market conditions. This means the initial rate can be lower than on 30-year fixed-rate mortgages, because the lender doesn't have to worry about where rates might be 10 or 20 years down the road.
The initial rate on an ARM can be quite a bargain. On a 5/1 ARM (rate is locked for five years, then resets every year thereafter), the initial rate can sometimes be a full point less than on a 30-year fixed, and often compare favorably with the rates on 15-year fixed-rate loans. Of course, the down side is that those rates may go up eventually, if interest rates rise overall.
In the current market, with mortgage rates still bouncing around near historic lows, it usually doesn't make much sense to get an ARM. If you're planning on long-term home ownership, get fixed-rate mortgage and lock in that low rate for the life of the loan.
The one exception is if you don't expect to live in the house very long. In that case, if you know you're only going to be there 5-7 years or so, you might not want to lock in a rate for three decades. You might decide to take the savings and get an ARM that will lock a lower rate for a few years until you sell and move on. But you want to be pretty sure of your timetable to do that.
Good deal or bad?
Unlike the bad old days before the crash, there aren't a lot of loan products these days that are simply a bad deal. Instead, your own plans and circumstances will dictate whether certain loan features are a good fit for you. Some things may sound appealing but on closer inspection may turn out to be less of a bargain than you hoped.