Interest Rates: How Are They Determined?
We all hear about interest rates during the home buying process, but we might not know much about about them. How exactly are mortgage interest rates calculated? And what factors determine your specific rate?
For starters, let’s be clear on the definition of mortgage interest rates and the different types of rates you can get. When you’re looking to buy a home, you’ll mostly likely need to take out a loan, that’s where a lender come in.
The mortgage loan you get from a lender consists of a couple different things, primarily principal and interest.
The principal is the initial amount of your loan, and the mortgage interest rate is the amount of interest that will be added to that principal balance over time. Interest is something you may have experienced before, like with your credit card or car loan — same idea. You may also think of your interest rate as the “rate of increase” to your balance over the lifetime of your loan. Understandably, a lower mortgage interest rate is preferred, because that may mean a lower monthly payment (although other factors also affect your monthly payment). And it’s not just about having a low vs. high interest rate — there are different types of rates, too. For example:
Fixed rates – where the interest rate will remain the same throughout the lifetime of your loan
Variable/Adjustable rates – where your interest rate may fluctuate over time
A variable or adjustable rate may often have limits and caps for how low or high it will fluctuate, so it may not increase over a certain percentage.
Now, how are interest rates determined? Upon receiving your loan application, a lender will review a handful of factors prior to determining your interest rate. You can control some of these items, so preparing is key to potentially getting an interest rate that’s a good fit for you.
Here’s what will impact your rate:
Your credit score
As you know, your credit score is an important figure that reflects your creditworthiness. This figure is calculated based on a number of factors that help lenders predict how reliable you are in paying back your loan. In short, the higher your credit score, the lower your interest rate — and vice versa.
Tip: Prior to applying for your loan (and thus your interest rate) take some steps to get your credit in tip-top shape.
New home's location
Geography may impact your mortgage interest rate. Rates will differ from state-to-state, as well as in more rural areas versus larger cities. Your lender will be able give you an idea of how geography has impacted your interest rate.
TIP: Understanding the various interest rates of your area may be helpful when narrowing down your home choices. So reach out to your mortgage banker during your house hunting phase.
Home's price and your down payment amount
The total price of the home you’re interested in buying will impact your interest rate. The price of the home minus your down payment will result in the total amount you need to borrow. Generally speaking, if you pay a larger down payment (thus needing a smaller loan), your interest rate will be lower.
Your debt-to-income ratio
In addition to your credit score, lenders will review your debt-to-income (DTI) ratio. This figure illustrates the percentage of your income that goes toward your monthly housing expenses and debts. A higher DTI ratio indicates that you have less expendable income. Less expendable income, the more difficulty you may have repaying your loan. This in turn would indicate more risk for a lender and would result in a higher interest rate.
Interest rate type
As we discussed earlier, there are different types of interest rates. Depending on which rate type you select (or which one you are offered), the actual figure of your interest rate will vary. Typically, you will get a lower rate initially with an adjustable rate — but it may increase dramatically over time.
The loan term
This is the amount of time you have to repay the loan. Understandably, committing to paying the loan back faster will result in a lower interest rate, whereas a longer loan term would typically have a higher interest rate. Ask your mortgage banker to give you a few different snapshots of various loan terms and how they’ll impact your interest rate.
Your loan type
There are multiple types of loans and loan categories such as conventional, FHA and VA. Among the differences between each type of loan is the variance in interest rate for each.
The market's climate
The health of the market will most definitely impact your personal interest rate. Market trends, conditions and government regulations will cause rates to either increase or decrease. For more information on mortgage interest rates, contact your mortgage banker.