How to Minimize Your Total Borrowing Cost When Shopping for a Mortgage
Buying a home is expensive, but there are additional costs you might not know about when you have a mortgage. Although a low interest rate is key, there are a number of other costs that can make borrowing more expensive.
Here’s an overview of some of the things that can add to your borrowing costs and what you can do to reduce the amount you pay.
Your mortgage rate will determine how much interest you pay and is typically the largest factor in determining your overall borrowing costs. Despite a set loan amount, your interest cost can fluctuate greatly depending on the competitiveness of your interest rate.
For example, if you get a $400,000 mortgage with a 25-year amortization and a five-year fixed rate of 2.29%, you’ll pay $105,018.20 over the first five years. Of that, $42,127.25 will be interest payments and $62,890.95 will go towards paying your principal.
But if you borrow the same amount, choose the same amortization and secure a five-year fixed rate of 1.69%, you’ll pay $98,074.35 over the first five years, $30,941.91 of that being interest cost and $67,132.41 going towards your principal. That’s a savings of nearly $12,000.
To get a better mortgage rate, you want to shop around and check a rate comparison site. Of course, you also want to ensure you have good credit to qualify for the best mortgage rate.
Shopping for a mortgage shouldn’t cost you anything, but there are times when you will have to pay some fees. For instance, a mortgage broker doesn’t typically charge you a fee if you’re a qualified borrower because the lender pays them a finder’s fee.
However, when you decide to use a mortgage broker and the mortgage specialist at your financial institution or use two brokers at the same time, you may need to pay the first broker for the work they’ve done if you end up not using their services. A broker may ask you to sign an exclusivity agreement. But if you decide at the last minute to use a different broker or get a mortgage from your financial institution, expect to pay up.
When working with a mortgage broker, ask if there’s an exclusivity agreement and how much it will cost you if you break the agreement.
In cases that require more complex financing arrangements (such as higher-risk private lending), your broker will usually charge you a fee for their services. This can be a flat fee or a percentage of your mortgage. Unfortunately, this cost typically can’t be avoided.
There can also be a fee if you decide to convert your mortgage from a variable to a fixed rate in the future if interest rates rise. Check with your mortgage broker or specialist to see what the costs are before choosing a variable-rate mortgage.
And there are fees if you break your mortgage, such as discharge and reinvestment fees. Find out what these are and if they’re up for negotiation before choosing a mortgage.
When mortgage rates fall significantly, it might make sense to break your mortgage and refinance. Other reasons to refinance may be using some of the equity in your home to pay for a renovation or pay off high-interest debt.
By refinancing, you pay off your current mortgage and replace it with a new one with different terms, such as the interest rate, length of the term, amortization period and payment frequency. You’ll usually pay a penalty for refinancing (see below).
However, some lenders offer mortgages at a very low rate, but that comes with restrictive terms. This could prevent you from switching lenders except if you sell your home. If you want to refinance before the term is up, you’re out of luck. This can leave you paying a high interest rate for years, even if it would have been cheaper paying a penalty to switch to a different lender at a lower rate.
To avoid this from happening, ensure that your mortgage doesn’t include restrictions on breaking, so you don’t end up trapped with your current mortgage until the end of the term.
Some penalties come with a mortgage, especially when you decide to break the mortgage.
Variable-rate mortgages generally have lower penalties compared to fixed-rate mortgages. The fee for breaking a variable-rate mortgage is three months’ interest on the amount you still owe.
But on a fixed-rate mortgage, the penalty is the higher of either three months’ interest or the interest rate differential (IRD). The IRD is the difference between the original rate and the current rate the lender would charge if it were to loan out the funds remaining on your mortgage today. This is where things can get costly. If rates have declined significantly, it’s not unreasonable to face a penalty of five figures or more.
In order to avoid a penalty for breaking your mortgage or to reduce the amount you have to pay, there are a couple of options, such as porting your mortgage or making prepayments.
If you expect to move before the end of your mortgage, you may have the option of porting your mortgage. In other words, you can still have the same mortgage, rate and conditions, except the loan will be transferred to your new property. You still need to qualify for the ported mortgage, but this will allow you to avoid breaking your mortgage and having to pay the penalty.
Before signing on the dotted line, check with your lender if you’re allowed to port your mortgage. This can potentially save you thousands of dollars.
Many lenders allow you to make additional payments over the term of your mortgage. Called prepayments, these can usually be made once a year and you’re limited to paying a certain percentage of the amount you borrowed.
If you have to break your mortgage, making sizable prepayments ahead of time can reduce the size of the penalty you have to pay since it will be based on a lower balance.
Ensure you have the ability to prepay. Prepayments are optional, but they can save you money down the road.
The benefits of flexibility
While many mortgage shoppers focus on securing the lowest mortgage rate, it could end up costing you more in the long run if it doesn’t provide any features or flexibility. A flexible mortgage can outweigh the benefits of a lower rate, especially if it means minimal penalties in the event you need to break your mortgage.