The five most important points from this article:
- Banks and lenders offer different mortgage rates.
- Risk-based pricing has a lot to do with it.
- The type of loan you use can also influence the rate.
- You can use the ‘Loan Estimate’ document to compare costs.
- Shopping around could save you thousands of dollars.
When shopping for a home loan, it’s always wise to compare offers from several different lenders. Surprisingly, however, a lot of borrowers choose the first offer they receive. Past surveys have shown that more than 50% of borrowers did not compare rates. And that’s a costly mistake.
Why? Because different mortgage lenders offer different interest rates to borrowers. Mortgage pricing is not a “one-size-fits-all” situation. Instead, it can vary greatly from one lender to the next.
Why Lenders Offer Different Mortgage Rates
Let’s start with the most important concept you need to know. Different banks and mortgage lenders might offer different mortgage rates — even to the same borrower. Knowing this, you can see the value of shopping around and gathering multiple quotes.
The next logical question is: why do banks and lenders offer different mortgage rates?
There are several reasons for this, and risk has a lot to do with it. Mortgage pricing (i.e., the fees and interest rates charged for a home loan) can vary from one lender to the next. These variations are largely driven by risk, as explained below.
Other factors can account for these differences. For instance, a borrower’s credit score and the size of the down payment could result in a lower or higher mortgage rate. The type of loan being used can also make a difference when it comes to interest.
The Concept of Risk-Based Pricing
Within the mortgage and banking world, there’s a concept known as “risk-based pricing.” As a borrower, you need to understand this practice, because it directly affects your interest rate and other loan-related costs.
According to the Consumer Financial Protection Bureau (CFPB):
“Risk-based pricing occurs when lenders offer different consumers different interest rates or other loan terms, based on the estimated risk that the consumers will fail to pay back their loans.”
Source: What is risk-based pricing? (CFPB.gov)
Here’s the short version. Mortgage lenders tend to charge higher interest rates for “riskier” borrowers, while offering lower rates to “safer” borrowers who are deemed to be a lower risk. This is one of the main reasons why mortgage lenders offer different rates to borrowers.
Lenders also have different procedures for “measuring” or assessing risk, along with different appetites for risk. No two mortgage companies handle it the exact same way. It can vary from one company to the next, and thus pricing varies as well.
So, how do mortgage lenders measure risk?
One method is to analyze the borrower’s past credit history. Credit scores essentially rate borrowers based on their previous borrowing history (credit cards, car loans, etc.). A borrower who makes all payments on time will have a higher score. A borrower with a pattern of missed payments or delinquencies will have a lower score.
Statistically speaking, a person with a lower credit score is more likely to default on a mortgage loan. So they are seen as a bigger risk, and charged a higher mortgage rate as a result.
Mortgage lenders use other factors to measure risk, as well. They might consider the size of the down payment, the borrower’s employment and income history, the amount of total debt they have, and more.
As mentioned, lenders have different methods for assessing risk and pricing loans:
- One company might look at your financial situation and view you as an extremely low-risk borrower, with a very low probability of default.
- Another company might see that you have a great credit score, but have an issue with the amount of debt you carry in relation to your income.
- A third lender might put more emphasis on down payments, reserving their best mortgage rates for borrowers who put down 20%.
- And so on…
So, risk-based pricing is one reason why lenders offer different mortgage rates to different borrowers. The type of home loan being used also plays a role. So let’s explore that topic next.
The Type of Mortgage Also Makes a Difference
The type of loan you use can partly determine the interest rate you receive.
For instance, let’s consider the difference between the 15-year fixed-rate mortgage and its longer-term counterpart, the 30-year fixed. Generally speaking, banks and lenders tend to charge more for home loans with a longer repayment period. In contrast, shorter term mortgages tend to have lower interest rates.
If you look at the weekly mortgage rate survey conducted by Freddie Mac, you’ll notice that the average rate for a 30-year fixed loan usually tracks higher than the average for a 15-year mortgage. And the 5-year adjustable-rate mortgage (ARM), usually offers the lowest rates — at least initially.
Mortgage rates can also vary based on the particular loan program you’re using. There are several broad categories of home loans, including conventional, FHA and VA. The amount of interest charged can vary, sometimes significantly, depending on the type of mortgage being used.
Using the ‘Loan Estimate’ to Compare Costs
At this point, you might feel overwhelmed by the complexity and intricacies of mortgage pricing. If different banks and lenders offer different rates, how can you compare one offer to another?
After all, we haven’t even covered the other fees that mortgage lenders can charge, such as origination and underwriting fees.
Fortunately, there are two items that can help you compare offers more efficiently:
- Loan Estimate — Mortgage lenders are required to provide borrowers with a Loan Estimate form shortly after they apply for a loan. This document, designed by federal financial regulators, gives you all sorts of information about your loan. Among other things, it shows the total costs associated with the loan (not just the rate). This makes it easier to compared one mortgage offer to another.
- APR — The annual percentage rate, or APR, represents the total costs of the loan. It includes the mortgage interest rate, but also other charges and fees such as buyer closing costs, mortgage insurance, origination fees and more. You can’t just compare rates. You have to look at the full cost of borrowing, and that’s what the APR shows you.
Page 3 of the “Loan Estimate” document actually shows you the APR, along with some other cost-related information. So it’s a very useful tool when it comes to comparison shopping. Borrowers can obtain Loan Estimates from several different lenders, and then choose the best one based on the APR and other factors.
The image above shows the applicable part of the Loan Estimate form, where it mentions the APR. As you can see, it also shows the total amount you’ll have paid over the first five years of the term, factoring in the mortgage rate and all other loan costs. That’s good information to have up front.
Shopping for the Best Rate Can Save You $$$
To recap: Mortgage lenders commonly charge different rates for borrowers, and for a number of reasons. But there are smart ways to comparison shop from one lender to the next, such as using the APR and Loan Estimate.
You might wonder why we place so much emphasis on “shopping around” and gathering multiple offers. After all, that kind of strategy takes time and effort. Wouldn’t it be easier to choose the first offer, instead of trying to shave a few basis points off the interest rate?
Yes, it would be easier. But the easy path might end up costing you more over the long run.
Even saving a fraction of a percent on a mortgage rate could save you thousands of dollars over the life of the loan. And even if you only stay in the home for a few years before selling, it can still make a big difference.
The infographic below shows the difference in costs associated with a $200,000 home loan with slightly different interest rates. Note that the amount being borrowed is the same for all three scenarios. The difference is the rate that’s applied to the loan.
As you can see, even a seemingly small difference in the mortgage rate can make a big difference — even over the short term.
We hope this article has given you a better understanding of why banks and lenders offer different rates to loan applicants, and how you can shop smartly for the best deal.
Brandon Cornett
Brandon Cornett is a veteran real estate market analyst, reporter, and creator of the Home Buying Institute. He has been covering the U.S. real estate market for more than 15 years. About the author