People can feel overwhelmed comparing complex options, and they retreat to the simplicity of sticking to a first alternative, even against their own financial interest. Such were the findings of Richard Thaler, whose paper won the 2017 Nobel Prize for economics.
Mortgages are definitely complex, but you can ease the hassle by comparing estimates to estimates. Terminology matters: insist on estimates.
You might ask for a mortgage estimate, but the lender sends another kind of paperwork, something more akin to a sales brochure. It happens more often than you might expect considering there has been a law since 2015 requiring lenders to supply official loan estimates within three days of receiving your application. So why don't they? The substitute paperwork isn't just faster for the lender, but it is also designed to disguise negatives and draw your attention away from consequences.
What a Loan Estimate Shows
A true loan estimate runs down all of the important details over three pages, including:
- Your estimated monthly payment
- Interest rate
- Closing costs
- Any prepayment penalty and other key features of the loan
A loan estimate also clearly indicates which details can change before closing. The substitute paperwork nearly always glosses over impending, surprise changes.
To eliminate as much of the confusion as you can when comparing mortgage offers, be sure to have true estimates in front of you. That way you are comparing apples to apples.
What to Look for in Each Estimate
Estimates are designed to show the most important details about a loan in clear terms. The first thing to check with any mortgage estimate is that it reflects what you discussed with the lender. Verify the loan term (30 years, 15 years, etc.), purpose (purchase, refinance), product (fixed rate, adjustable rate), and loan type (conventional, FHA, VA). This info should be right at the top.
Also at the top is the indicator of a rate lock. If you expected the rate to be locked, verify that it is. You should see an expiration date if there's a lock.
In the section about loan terms, check that the loan amount and interest rate are what you expected. If something looks different, ask the lender to explain. This area of the estimate will also indicate whether the rate or payment can ever increase and also whether there's a prepayment penalty.
Verify that there is no balloon payment. "This feature is risky," says the Consumer Financial Protection Bureau. "If your loan includes a balloon payment, ask your lender about your other options." Ask for a new estimate without the risky feature so you can see the difference in costs for a loan that's less risky to you.
If your name is misspelled, or other key details are wrong, don’t assume they will get fixed along the way. Get them fixed now. Some errors, such as a typo in the address of the property you plan to purchase, may seem minor but are actually major errors that could affect your rate and costs.
In the section about projected payments you will see an estimate of your monthly payment, any mortgage insurance premium, and estimated taxes. Does the Estimated Total Monthly Payment match your expectations? Do you have items under Estimated Taxes, Insurance & Assessments that are not escrowed?
Beneath this, but usually still on the first page, you come to Costs at Closing. Do you have enough cash to pay the estimated total costs?
While you can often roll closing costs into the loan balance, doing so makes them significantly more expensive. For example, let's say you borrow $225,000 at 2.95% for 30 years and the closing costs are $8,000. You have the choice of paying the closing costs out of pocket or bumping up the balance to $233,000 to absorb them. If you make the second choice, each month you will pay $33 more—doesn't sound too bad, right? But in the end you will have paid $4,065 in interest on the $8,000 closing costs, in effect paying 50% more than they would have cost up front.
The Comparison Calculations
Gathered in the Comparisons section of a loan estimate (example above), usually on the last page, are several calculations that help you compare loans. The calculations turn big concepts into concrete, understandable numbers. These calculations will be specific to the kind of loan (conventional, FHA, VA, etc.). Only compare loan estimates for the same type of loan.
- In 5 Years. This is like a peak at the amortization table, showing how much money you will have paid after five years and how much of that money went to the principal. Principal is equity. When comparing loans, which one buys you more of the house after five years?
- Annual Percentage Rate (APR). This is not your interest rate; it's the total cost of the loan expressed as a percentage, to make comparisons easier. APR is a more useful comparison than interest rate because it reveals the total cost of the loan. Two estimates might have nearly identical interest rates, but one's APR could be higher.
- Total Interest Percentage (TIP). Over the life of a loan, interest accumulates to a surprising degree. Here you see it expressed as a percentage of the loan amount. The TIP might be 65%-75%. Which of your estimates is lowest?
More Points of Comparison
Rates aren't the only thing to compare on mortgage estimates. On the second page of the loan estimate you will find details about the closing costs. Here's where you see more numbers that you can use to weigh one loan against another.
- Origination Charges. A good way to tell if you have a competitive loan offer is to compare origination fees among estimates. Depending on the lender, origination charges may be more or less itemized. Common fees include those for application, origination, underwriting, processing, verification, and rate locks. It’s the total that matters.
- Services You Cannot Shop For. These are services required and chosen by the lender. Compare the overall cost of the items in this section to the estimates from other lenders. Every lender chooses its own service providers, and some get better prices than others.
- Services You Can Shop For. The lender requires these services, but you can shop for them separately, starting with a list of approved providers that the lender should have included with the estimate. Some lenders will give you more choices than others will. You might be able to go off the list and find your own provider, but check with the lender before doing so and make sure your choice is approved.
Pit Lenders Against One Another
Request a few estimates not only so you have choices but also so you can get a competition started. It's not just about the interest rate but also the closing costs, points, and fees. The lender with the lowest upfront rate might not be the best for you over the life of the loan, but you can send that loan estimate to your preferred lender and ask for a match.
Some lenders have always been more efficient than others. Today's most efficient lenders lower their overhead costs with online applications and software-driven analysis and pass along the savings to borrowers. Other lenders make their profit by dealing in high volume and can therefore afford to charge lower rates and fees.
Lenders can't always budge on their rate or closing costs, but it's worthwhile to send the better estimate to them and ask if they can update their estimate right away to compete.