Mortgages: Be Sure You Get the Best Deal
As a house is likely the largest single investment you'll ever make, there's a good chance you'll get a mortgage to finance it. Mortgages are loans that are secured by specified real estate – namely, the house the loan is used to purchase. Depending on factors such as your credit score, employment history and debt-to-income ratio, a lender may offer you a prime or subprime mortgage or something in between, called an Alt-A mortgage. Let's take a quick look at the different mortgage categories and how you can be sure you're getting the best deal you can. (For more, see Finding the Best Mortgage Rates in 2016.)Prime Mortgages
Prime mortgages meet the quality standards set forth by Fannie Mae (the Federal National Mortgage Association) and Freddie Mac (the Federal Home Loan Mortgage Corporation), the two government-sponsored enterprises that provide a secondary market in home mortgages by purchasing mortgages from originating lenders. According to the Federal Reserve, a prime residential mortgage is a mortgage for a borrower whose credit scores are 740 or higher, whose debt-to-income ratios are lower than average and whose mortgage features the standard amortization schedule common to a fixed-rate or an adjustable-rate mortgage.
Borrowers also have to make a considerable down payment – typically 10% to 20% – the idea being that if you've got skin in the game you're less likely to default. Because borrowers with better credit scores and debt-to-income ratios tend to be lower risk, they are offered the lowest interest rates – currently about 4% for a 30-year fixed rate mortgage – which can save tens of thousands of dollars over the life of loan.Subprime Mortgages
Subprime mortgages are offered to borrowers who have lower credit ratings and FICO credit scores below about 640, though the exact cutoff depends on the lender. Because of the increased risk to lenders, these loans carry higher interest rates – such as 6% to 10%.
There are several kinds of subprime mortgage structures. The most common is the adjustable-rate mortgage (ARM), which charges a fixed-rate teaser rate at first, then switches to a floating rate based on an index such as LIBOR, plus margin, for the remainder of the loan. An example of an ARM is a 2/28 loan, which is a 30-year mortgage that has a fixed interest rate for the first two years before being adjusted. While these loans often start with a reasonable interest rate, once they switch to the higher variable rate the mortgage payments increase substantially, which can cause many borrowers to go into default.Alt-A Mortgages
Alt-A mortgages fall somewhere in between the prime or subprime categories. One of the defining characteristics of an Alt-A mortgage is that it is typically a low-doc or no-doc loan, meaning the lender doesn't require much (if any) documentation to prove a borrower's income, assets or expenses. This opens the door to fraudulent mortgage practices, as both lender and borrower could exaggerate numbers in order to secure a larger mortgage (which means more money for the lender and more house for the borrower).
While Alt-A borrowers typically have credit scores of at least 700 – well above the cutoff for subprime loans – these loans tend to allow relatively low down payments, higher loan-to-value ratios and more flexibility when it comes to the borrower's debt-to-income ratio. These concessions enable certain borrowers to buy more house than they can reasonably afford, increasing the likelihood of default. That being said, low-doc and no-doc loans can be helpful if you actually have a good income but can't substantiate it because you earn it sporadically (for example, if you're self-employed).
Because Alt-As are viewed as somewhat risky (falling somewhere between prime and subprime), interest rates tend to be higher than those of prime mortgages but lower than subprime – somewhere around 5.5% to 8%, depending on the lender and the borrower's situation. Alt-A Mortgages: How They Work will give you more details on the fine points.A Side Note on Alt-As
During the real estate boom heading up to the subprime mortgage crisis that began in 2007, Alt-As were extremely popular. Lenders were quick to peddle them, and borrowers were quick to snap them up. They became known as liar loans, because borrowers and lenders were able to exaggerate income and/or assets to qualify the borrower for a bigger mortgage.
As a result, many of the Alt-A mortgages issued during the real estate boom went into default because borrowers had no way to meet high monthly mortgage payments on what amounted to fictional income levels. Alt-As were by no means the only reason for the mortgage crisis, but no-doc, low-doc and NINA (no income/no asset) loans definitely played a role in allowing people to borrow beyond their means.Getting the Best Possible Mortgage
Alt-A and subprime mortgages carry interest rates that are higher than those of prime mortgages. The higher the interest rate, the more you pay each month, and the more you ultimately pay for your home. To compare, let's take a look at a 30-year fixed-rate mortgage for $200,000. At the prime rate – 4% in this example – your monthly payment would be $955. Over the life of the loan, you would pay $143,739 in interest – so you'd actually pay back a total of $343,739.
Now assume you get the same 30-year fixed rate mortgage for $200,000, but this time you are offered a subprime rate of 6%. Your monthly payment would be $1,199, and you'd pay a total of $231,677 in interest, bringing the total amount you pay back to $431,677. That seemingly small change in interest cost you $87,938.
What's important to realize is this: Just because a lender offers you a mortgage with an Alt-A or subprime rate doesn't mean you wouldn't qualify for a prime-rate mortgage with a different lender. Lenders and brokers generally are under no obligation to offer you the best deal available. It's well worth the effort to shop around, so you can compare offers from different lenders and pick the one that delivers the best possible terms.The Bottom Line
Taking the time to find a better interest rate can save you tens of thousands of dollars over the course of a loan. Another money-saving idea to consider: If you qualify for X amount of mortgage, there's nothing that says you have to spend that much. Make sure you need that much house before buying in that price range. You could well be happy in a smaller house – or one a little farther away from work – and spend that extra money on something else (or, even better, save it).
If you don't qualify for the interest rate you want, consider delaying homeownership while you work on improving your credit rating and score. Some good strategies when considering How to Improve Your Chance of Getting a Mortgage are to review your credit report and fix any mistakes, try to pay down debt and lower your debt-to-income ratio by reducing your monthly recurring debt and/or increasing your gross monthly income.