A Guide to Mortgage Shopping

Aug. 27, 2007 — -- With all the news about mortgage lenders struggling and borrowers defaulting, it seems like a good time to review some principles about shopping for a mortgage. If you're looking at an adjustable rate loan that is about to go up or if you've got a "creative mortgage," it may be time to switch to a more basic loan. The world of mortgages is baffling, but here's what matters: who provides your loan, what loan you get and how you manage that loan later.

First of all, know the difference between a mortgage broker and a mortgage lender. Mortgage brokers almost never use the word "broker" in their business names. In fact, they often use names like "XYZ Home Loans," which imply that they make home loans. They don't. Mortgage brokers don't have any money to give you. Zero. Zilch. Nada. They are simply professional shoppers who approach lenders for you. There are millions of mortgage brokers nationwide. They tend to be small, locally based businesses. One caution: if you use a mortgage broker and things go wrong, the broker can blame the lender and the lender will blame the broker. It can be hard to get satisfaction when that happens.

Mortgage lenders are usually giant companies that do business nationwide. Some are full-service banks. Others specialize in mortgages. Some mortgage lenders don't really do business with consumers. They are in the field simply to make home loans, then sell those loans to investors as soon as possible. I prefer mortgage lenders who keep their loans. They have more incentive to be consumer-friendly, since they have long-term relationships with their customers.

If you have tip-top credit and enough cash for a big down payment, I suggest you at least try to shop for loans directly through mortgage lenders. This advice comes from the basic principle that it's best to cut out middlemen whenever possible. Every middleman has to be paid, right? Information is so accessible these days that shopping for interest rates on your own is pretty easy.

Look in the paper. Call the bank where you have your checking account. Go online. I shopped for my mortgage on the Internet, although my trust broke down when it came time to actually apply. For that, I wanted to speak to a live human. On the down side, since mortgage lenders may not deal directly with customers very often, they can be downright klutzy about processing your paperwork. My mortgage lender was clueless. Check out your mortgage lender's reputation before you do a deal.

If your loan-shopping is complicated by a lot of factors, that's when a mortgage broker can really be worth the commission. For example, if you have poor credit, a mortgage broker can scour the financial world to find you a loan you might not be able to find on your own. If you have little cash for your down payment, a mortgage broker can advise you on creative ways to keep your costs down. If interest rates are high across the board, a mortgage broker may have some sound coping strategies. Since brokers do nothing but serve customers, they may be better than lenders at streamlining their requests for paperwork. Be sure to check the broker's reputation. It's not very hard to become a mortgage broker, so you want to be sure you're dealing with a pro.

Different Types of Loans

After you choose your lender or broker, you have to choose what type of loan you want.

Fixed-rate mortgages are best when interest rates are low and you plan to stay in the home for a long time. That way you lock in a good deal and your monthly payments stay steady for the life of the loan. When rates are rock bottom, I see no reason to pay points. A point is a fee equal to 1 percent of the purchase price of the home. It's used to "buy down" the interest rate. If the rate is already low and fixed, you don't need to make it any lower. Some brokers and lenders will try to get you to pay points anyway, because typically points generate more up-front profit for them.

Adjustable-rate mortgages, or ARMs, work well when interest rates are high and/or you don't plan to live in the house very long. ARMs typically start with a lower, "teaser" rate, which can help you make your monthly payments. It can also help you qualify for a more expensive home than you would with a fixed-rate loan. It's a bit of a gamble. You're hoping that interest rates will go down before it's time for your adjustable-rate mortgage to adjust. That way you can refinance and get a decent fixed rate. Alternatively, you can sell the home before your rate goes up. Most ARMs have a maximum cap for your protection. To be fair, an ARM should adjust upward and downward, depending on market conditions. But some predatory lenders sell adjustable rate mortgages that start high, only adjust upward, and have no cap.

The Federal Trade Commission cautions borrowers against what it calls "creative financing" packages.

Example 1: A loan that starts out below-market, but in which both the interest rate and the monthly payment grow every year for the remainder of the loan, regardless of market conditions.

Example 2: Some mortgages have high interest rates but still offer low monthly payments. If the payments are not enough to cover the principal and interest, the difference is added to the principal. You could actually end up owing more at the end of the loan term than you did in the beginning.

Example 3: To keep early payments low, some lenders ask borrowers to make a "balloon" payment at the end of the loan. The amount is usually so massive that the borrowers have to refinance. That generates more closing fees for the lender and exposes you to whatever the going interest rate is, which may not be at all favorable.

Once you've chosen a lender or broker, you need to decide whether to "lock in" today's going interest rate, or gamble that rates will go down between now and your closing. Have the lender or broker sign a lock-in document that states the interest rate and number of points you will be paying. That way, even if rates go up, you are set. Most banks will only guarantee an interest rate for 60 days. If you feel strongly that interest rates will go down before you close, you can choose to "float" your interest rate. You can also request a deal in which the interest rate can decrease, but not increase while you wait to close. Not all banks offer this service, so you might want to find one that does.

How Much Money to Put Down?

These days some lenders will give you a mortgage without any down payment at all. But if you can put 20 percent down, that's still ideal. That's the threshold for avoiding private mortgage insurance, or PMI. PMI isn't anything that benefits you. It's something lenders demand in order to protect themselves in case you stop paying back your loan. In addition to putting down 20 percent, there are other innovative ways to structure a first and second mortgage and avoid PMI. Ask a professional.

If you do end up paying PMI, you get to stop as soon as you have 20 to 22 percent equity in your home. The Homeowners' Protection Act of 1998 says that lenders must terminate your PMI when you reach 22 percent, based on the original property value. Keep track of that. Some lenders and insurance companies fail to tell you when your PMI obligation is over, because they want to continue collecting the pricey premiums. If yours is a "high risk" loan because you have poor credit or if you have made late payments on your mortgage, your lender has a right to keep charging for PMI.

If you can pay off your mortgage in less than the 15, 20 or 30 years planned, you will save thousands of dollars in interest. Just make sure there is no penalty for early repayment. In some states, prepayment penalties are illegal, in others they're quite common. There are a couple different ways to set up your own early repayment system.

One way is to simply send extra money each month when you pay your mortgage. Most mortgage companies provide a blank line for you to write-in the extra amount you are sending. Just be sure to note that your extra money is to go toward principal. Paying extra toward your principal reduces how much interest you owe in the long run. This method is flexible, so if you're pinched for cash one month, you can send less. If you're flush another month, send more.

If you need a more structured approach, consider this: Most of us pay our mortgage bills once a month. But most of us get paid every two weeks. If you set aside half your mortgage money every pay period, you will end up with an extra month's payment by the end of the year. Send that money in, say it's for principal, and you'll be way ahead on your mortgage.

Because prepaying is such a great benefit, some companies are trying to cash in. These companies offer "mortgage savings plans" for a price. The company collects your extra money every two weeks and sets it aside for you. This method certainly provides a dose of discipline, but it comes at a price. Mortgage savings plans typically cost about $500 to set up and $2.50 for each withdrawal. If you experience hard times, you still have to pay, and if you don't, you could face late fees. To make matters worse, the company holding your mortgage money makes interest on it. Wouldn't you rather earn that interest yourself?

To be a Savvy Consumer …

Do your homework:

If you're a first-time homebuyer, get a hold of every book and pamphlet you can about mortgages. Also consider taking a home buying class. Fannie Mae and Freddie Mac offer first-time homebuyer classes. If you complete the class, you prequalify for a loan.

Shop for mortgages yourself, if you feel confident and comfortable doing so.

Figure out who's who in your area. Let's see, is this company a mortgage lender or a mortgage broker?

Check the reputations of lenders and brokers by contacting the BBB, your county and state consumer protection offices and possibly your state department of banking.

Determine what kind of loan you want, based on interest rates, your credit history, the size of your down payment and the cost of the home.

Demand a copy of the terms of your loan before closing. Read and understand it, or have a lawyer read and understand it for you. Comb the contract for signs of "creative financing" deals that could get you in trouble.

Avoid Private Mortgage Insurance if you can. If you can't, keep track of it and stop paying as soon as possible.

Figure out if your loan has prepayment penalties and whether they're legal in your area. If not, work out a plan to pay extra each month without outsourcing your willpower to an outside company.

How to Complain:

To lodge a complaint against a mortgage broker, contact your county and state consumer protection offices and the BBB. Do the same for a mortgage lender, but also find out what agency regulates mortgage lenders in your state. It could be the department of banking. If your loan is insured by the federal government, contact HUD (for FHA loans) or the Veteran's Administration (for VA loans).