What does it take to get the lowest mortgage rate on a home loan in 2012? We set out to find an answer. And, as you will soon see, it’s a hard question to answer.
At the time this article was published (2/12/12), the average rate on a 30-year fixed mortgage was 3.87%. The 5-year ARM loan was an astoundingly low 2.84%. Those were the lowest mortgage rates ever recorded at the time of publication. And everyone is writing about it, from the Wall Street Journal to your local newspaper.
But nobody is explaining what it takes to qualify for the lowest mortgage rates available. So we took a stab at it. We queried 45 mortgage brokers and lenders across the United States, and asked them this very question. We received responses from 27 of them. The results are presented in the infographic below.
A Hard Question to Answer
As it turns out, there isn’t a specific “profile” for a well-qualified borrower, the type of borrower who is offered the lowest mortgage rates available. Rates vary based on the lender, the loan program, and the borrower’s individual qualifications. There are variables on top of variables.
This is a question we have generally avoided in the past. With so many variables in play, it’s hard to create a “profile” of a highly qualified mortgage applicant. At the same time, this is also one of the most common questions we receive from our readers. And being a publisher is about giving readers what they want, as much as possible. So we compiled all of the responses and did our best to average them out.
Individual Factors: Qualifying for the Lowest Rates
The infographic at the top of this page mentions four qualification criteria — credit score, down payment debt ratio and points. Here’s an explanation of what they are, and how they might help you secure the lowest mortgage rates available in 2012:
- Credit Scores — Your credit score is computed based on the information found within your credit reports. There are several scoring models in use today. The FICO score is the one most commonly used by mortgage lenders. It’s a three-digit number between 300 and 850, and it’s meant to show the lender how much risk you bring the table. Most of the lenders we heard from said they reserve their best mortgage rates for borrowers with FICO scores of 740 or higher. A few set the bar even higher, at 760+. You can obtain your reports for free through AnnualCreditReport.com, and you can get your FICO scores for a small fee through MyFICO.com.
- Down Payment — Mortgage lenders price their loans largely based on the amount of risk they face. Your down payment is meant to offset some of that risk. By putting more money down, you are also reducing the lender’s investment and risk. This can help you obtain a more favorable interest rate. Based on our survey, it seems many lenders offer their lowest mortgage rates to borrowers who put at least 25% down. Keep in mind this is for getting the best rate, not for getting approved. It’s a key distinction. Borrowers can get approved for a loan with a down payment as low as 3.5% (for FHA mortgages) or even 0% (for VA and USDA loans). More about down payments.
- Debt Ratio — Lenders will also want to know how much of your gross monthly income you are paying toward your debts. This is referred to as your debt-to-income ratio, or DTI. You have two ratios. Your front-end ratio only includes your housing-related debt. Your back-end ratio considers all of your other debts as well, in addition to your mortgage debt. Borrowers can get approved for a home loan with a back-end DTI ratio of 45%, and sometimes higher. But if you want to qualify for the lowest mortgage rates available, you’ll need a combined debt ratio no higher than 30% (based on what lenders told us). Again, there are exceptions to every rule.
- Interest Points — When you take out a loan to buy a house, you will have the option to pay “points” at closing to reduce your interest rate. These discounts points are a form of prepaid interest. One point equals one percent of the loan amount. It’s a trade-off that can work in your favor, if you keep the loan long enough. You pay more up front to secure the lowest possible mortgage rate, thereby reducing the size of your monthly payments. Each point you pay could shave down your interest rate by one-eighth to one-quarter of a percentage point. Most of the lenders we queried reserve their best rates for borrowers who pay at least one point at closing. More about points.
Some of these factors can offset others. For instance, if you have excellent credit and a large down payment, you might be offered the lender’s best rate — even if your debt ratios are less than ideal. The same goes for paying points at closing.
This list isn’t even exhaustive. Some of the lenders we spoke to also put an emphasis on cash reserves. This is extra money you have in the bank, aside from what’s needed for your down payment and closing costs.
We also posted this topic on the Q&A section of Trulia.com. Mortgage broker Deborah Garvin pointed out that “the type of property and occupancy can have more impact on the loan pricing than the credit profile of the borrower.”
Like I said, there are variables on top of variables. This is why it’s so hard to say what a borrower might need to get the lowest mortgage rate a lender can offer. But, if nothing else, this gives you a general definition of a well-qualified borrower in 2012.
Mortgage Rate Not the Only Factor to Consider
The news of record-low interest rates can create a sort of “rate fever” among home buyers and homeowners. Tunnel vision is one of the symptoms of this condition. Sure, it’s important to get the lowest possible rate on a mortgage loan. This is true whether you are buying or refinancing a home. A lower rate could save you thousands of dollars over the term of the loan. At the same time, there are other factors you need to consider, such as the total cost of the loan including all points and fees.
How many points will you have to pay? How much will your closing costs be with Lender A, as compared to Lender B? These are two additional points to consider when applying for a loan. The interest rate you receive on the loan is only one ingredient of a good deal.
A Mortgage Rate Scenario
Let’s say Lender A is offering you a rate of 4.1% on a 30-year fixed mortgage. They say it’s the lowest rate they have to offer. Lender B offers you 3.87%. At first glance, the second offer looks like the better deal. But Lender B is also charging you higher fees, and requiring you to pay more up front in the form of interest points. So your upfront, out-of-pocket costs will be $3,000 higher with the second lender.
The question you must ask yourself is: How long would you have to keep the loan to justify the higher upfront cost needed to obtain the lower rate?
Let’s do the math…
- With a rate of 4.1% on a $300,000 loan, the monthly payment would come to $1,449 per month over 30 years. *
- With a rate of 3.87% on the same loan, monthly payments would be $1,410 per month.
- That’s a difference of only $39 per month.
* Taxes and insurance have been removed from this equation, for the sake of simplicity.
So let’s revisit the question posed earlier. Let’s say you choose the loan with the lowest mortgage rate but the higher upfront costs. How long must you keep that loan to make up for the $3,000 in additional points and fees? To find your answer, you would divide $3,000 (the difference in closing costs) by $39 (the monthly amount saved with the lower rate).
3000 ÷ 39 = 76.9
The answer is 76.9. Let’s call it 77. This is the number of payments it would take to make the difference. After making 77 monthly payments (over 6.4 years), you would come out ahead in this scenario. But if you sell the house after four of five years, you’ve paid more in closing costs for no reason. You haven’t yet broken even.
There’s also the all-at-once nature of the upfront expense to consider. The difference in the higher rate is paid in small amounts ($39) on a monthly basis. The difference of paying more in closing costs to obtain a lower rate is paid all at once, and could add up to thousands of dollars. So consider your long-term plans and the amount of “extra” cash you have on hand when you buy the house.
It may seem like we are splitting hairs here. But this is how you need to look at things when shopping for a mortgage loan. One lender says they are willing to offer you their lowest mortgage rate — but at what cost? How much will you have to pay up front, in closing costs and interest points, to lock in the lower rate? There is more to mortgage shopping than the rate alone. It’s important. But it’s not all-important.