What factors affect my mortgage rate? This is a common question among home buyers and mortgage shoppers, especially those who have never been through the process before.
The truth is there are many factors that can influence the interest rate on your home loan. Your credit score, the type of loan you choose, and whether or not you use “discount points” are three of the biggest factors. But there are others as well. So let’s take a look at the different things that can affect your mortgage rate.
How Mortgage Lenders Price Their Loans
Mortgage interest rates are not standardized across the industry. They actually vary from one lender to the next and, more to the point, from one borrower to the next. Lenders set their mortgage rates in order to offset the risk of borrower default, and also to make some profit on the loan (it is a business after all).
They also determine their rates in a way that makes them competitive with other lenders. For instance, if a company wanted to attract more borrowers, it could simply offer lower mortgage rates and/or fewer fees than its competitors.
7 Factors That Affect Your Mortgage Rate
With that introduction aside, let’s look at seven specific factors that can affect your mortgage rate when shopping for a loan.
1. Risk-based pricing.
Risk is one of the primary factors that affect your mortgage rate. Banking and lending are risky businesses, because there’s always a chance the borrower will fail to repay his or her debt obligation down the road. This is referred to as “default.”
Generally speaking, riskier borrowers are charged higher interest rates than less risky borrowers. Learn more about risk-based pricing. This is one of the primary factors that will influence your mortgage rate.
The next logical question is: How do lenders measure risk from one borrower to the next? One of the tools they use is your credit score. So let’s talk about that next.
2. Your credit score.
Credit scores are three-digit numbers. They are based on the information found within your credit report (which includes all kinds of information from your borrowing history). If you tend to pay all of your bills on time, and maintain relatively low credit-card balances, you probably have a good credit score. On the contrary, people who routinely make late payments — or skip payments altogether — tend to have lower scores.
Mortgage lenders use credit scores for risk analysis, among other reasons. We talked about risk earlier. A borrower with a high (good) score is viewed as a lower risk, while a person with a low (bad) score is seen as a bigger risk. So this three-digit number is one of the major factors that can affect your mortgage rate.
Learn more about the connection between credit scores and mortgage rates.
3. The size of your down payment.
The amount of money you are willing to put down on the loan can also influence your interest rate. And once again, it has to do with risk.
Making a larger down payment results in a lower loan-to-value (LTV) ratio, which also reduces the level of risk for the lender. On the contrary, a smaller down payment results in a higher LTV, and could therefore result in a higher mortgage rate.
Here’s an in-depth explanation of the relationship between down payments and mortgage rates.
4. The type of home you’re buying.
Different types of properties have different risk levels associated with them, based on the historical likelihood of default. So, by extension, the type of property you are buying can also affect your mortgage rate.
Generally speaking, single-family homes that are purchased as a primary residence pose the lowest risk of default. Properties purchased as vacation or second homes tend to have a higher default rate. Lenders often charge higher rates for “riskier” properties, not to mention imposing stricter underwriting guidelines.
5. The amount of money you’re borrowing.
Larger loans are riskier than smaller ones, for the simple fact that there is more money involved and therefore a higher potential for loss.
As a result, borrowers who use conforming loans (which meet the size restrictions used by Freddie Mac and Fannie Mae) often qualify for lower mortgage rates than those who use jumbo loans (which are too big to be sold to Fannie or Freddie).
[Update for 2017: Over the last few years, industry surveys have shown that jumbo loans have lower rates, on average, than their conforming counterparts. This a reversal of the previous “norm.” It’s something all borrowers should be aware of, particularly those in pricier real estate markets where jumbo mortgages are common.]
6. Whether or not you pay “points” at closing.
Did you know you can secure a lower rate on your mortgage loan by paying a little more money up front, at closing? This is a common strategy used by borrowers who want to minimize their long-term interest costs (and don’t mind paying higher closing costs to achieve that goal).
This is another factor that can affect your mortgage rate, and it’s one you can control. A discount point is a form of prepaid interest. One point equals one percent of the loan amount. Your mortgage lender might offer you a lower rate if you agree to pay points at closing. It’s a trade-off. You’re paying more money up front, in the form of closing costs, but you’ll pay less in interest over time.
For more on this subject, check out our in-depth tutorial on discount points.
7. Shopping around for the best deal.
Different lenders offer different rates, based on their business models and their appetite for risk. That’s why it’s important to get more than offer before locking in your home loan.
A few years ago, a Standford University study showed that mortgage shoppers who got at least three quotes from lenders saved thousands of dollars on a $200,000 home loan.
Here’s a quote from the report:
“Given this conclusion, we ask what benefit a borrower who shopped from only two brokers passed up by not shopping from three or four. The answers are so large that we believe that most borrowers must have been unaware of the likely benefits of more shopping. For example, for a mortgage with $100,000 principal, a borrower would save a median of $981 by adding one more broker to the mix and $1,393 by adding two. And with $200,000 principal, the savings are $1,866 and $2,664.”
Here’s the full report in PDF format, if you’re interested.
So there you have them, seven factors that can influence your mortgage interest rate. Granted, these are not the only factors that come into play during the pricing process. But they are some of the most influential.
The bottom line is that it pays (literally) to shop around. Get quotes from different lenders, and ask them why you are being offering a certain rate. Ask what you can do to secure a lower rate on your loan, such as paying discount points. A reputable lender will take the time to sit down with you and explain your options.