What Determines Your Mortgage Rate?
Understanding mortgage rates can be frustrating. Maybe you've been shopping around for the lowest mortgage rate and are wondering why no one will quote you the rates you've seen advertised or read about in the news.
Here are some of the major things that determine the mortgage interest rate charged to individual consumers. Some may be obvious to you, others probably less so.
Most borrowers realize that their credit score is going to affect the type of interest rate they can get. What few of them know is exactly how much.
Most lenders group credit scores in brackets, with the top brackets getting the best rates. The highest bracket is typically for FICO credit scores of 740 or 760 and above, the second bracket usually begins at 700 or 720, then on down to 680, 660, 640 and 620, the last being about as low as you can go and still obtain a mortgage with most lenders.
Generally, interest rates increase by about 20 basis points each time you go down a bracket. So if borrowers in the 760 bracket are paying an average of 3.75 percent for a 30-year loan, those in the next bracket down will likely pay around 3.95 percent, though the steps get bigger toward the lower part of the scale. The Fair Isaac Corp., which created the FICO credit scoring system, provides a table on its web site, www.myfico.com, showing what current average interest rates are for different credit scores in various parts of the country.
Where you live affects your interest rate. Many people aren't aware of it, but mortgage rates vary from one part of the country to another. There's no hard and fast rule, but generally interest rates are somewhat higher in areas with a higher cost of living.
It's not a huge difference - for customers with good credit, about 10 to 15 basis points more (0.10-0.15 percentage points) if you're getting a mortgage in a high-cost state like California or New York versus lower-cost areas like Kansas, Idaho or Louisiana, according to the Fair Isaac Corp., creator of the FICO credit scoring system. That's about equal to an additional $10-$20 a month on a $250,000 30-year loan.
Another important number when determining interest rates is your debt-to-income ratio. Lenders want your total monthly debts, including your estimated new mortgage payment, to equal no more than 43 percent of your gross monthly income. The lower your debt-to-income ratio is, the better your odds of qualifying for a lower interest rate.
One of the reasons you may not be able to obtain the same interest rates you read about or see advertised is that those rates often include points. Points are a form of pre-paid interest that can be used to lower your interest rate.
Each point costs a fee equal to 1 percent of the loan amount and typically reduces your mortgage rate by about one-eighth of a percentage point. So if you're borrowing $250,000 and the standard interest rate is 4.00 percent, you can buy a point for $2,500 and reduce your rate to 3.875 percent.
Negative points are sometimes used as a way to pay for closing costs and other fees. So, in the example above, taking a single negative point would raise the interest rate to 4.125 percent to defray $2,500 in closing costs and fees.
The size of your down payment may affect your interest rate. For lenders, a smaller down payment means a riskier loan, so they tend to charge higher rates. However, if you put less than 20 percent down, you'll have to buy private mortgage insurance (PMI). This gives the lender some protection in the event of a default, making the loan less risky. In fact, in some cases you may even get a better interest rate than someone who puts down 20 percent.
Keep in mind, though, that the annual charge for PMI is equal to about one-half percent of the amount borrowed, so it's like raising your interest rate by half a percent. Also, the rate will likely vary for both PMI- and non-PMI loans. For example, someone putting down 5 percent may pay a higher rate than someone putting down 10 percent while someone putting down 30 percent will likely get a better rate than if they'd put down 20 percent.
Your interest-rate lock
Once you are approved for a mortgage loan, you can lock in your mortgage rate. This way, if rates rise before your loan officially closes, a process that can take 30 days or longer, your rate will remain locked in place. Grabel said that most loans are priced based on a 60-day lock period. If you instead go with a 30-day lock, you might qualify for a slightly lower interest rate.
You do take a chance, though. If your loan doesn't close within 30 days, your lock will expire, and your interest rate could rise before you sign your closing documents.
Some people overlook this, but the interest rate you pay will vary according to the lender you go with. Lenders participate in different lending programs and structure their loans and fees in different ways. The lender who provides the lowest interest rate for a friend may not have the best deal for you. This is why it pays to shop around for a mortgage - you don't know who will have the best deal until you compare several offers.
Notice too, that you're looking for the best deal - not necessarily the lowest mortgage interest rate. Because of the way different fees and closing costs get folded into a loan, a mortgage with a seemingly low rate could actually end up costing you more over the long run than another with a slightly higher rate, because you're paying more fees up front. A convenient way to check this is to compare the annual percentage rate (APR) on different loan offers, which is a way of estimating the total cost of a loan.
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