What Determines Your Mortgage Rate?

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    • FNBO

      May 14 2024

What Determines Your Mortgage Rate?

Purchasing a home is probably one of the largest financial transactions you will make in your lifetime. For most people, that’s true! The interest rate on your mortgage impacts the total cost of your loan over time so it’s important to understand the factors that influence an interest rate, so that you can manage the ones over which you have control.

There are several variables that determine your interest rate—some of which are out of your control--inflation, rate of economic growth, Federal Reserve monetary policy, and housing market conditions. The good news is there are plenty of variables you can control. This article explains what they are and how you can use them to get the best rate for your financial position.

1.       Credit Score
Your credit score plays a major role in your mortgage rate. It’s a three-digit number that tells a lender how likely you are to pay your credit obligations and is based on financial factors, including how much debt you owe, how much credit is available to you, and your history of debt payment. Borrowers with good or excellent credit scores (690-720+) may qualify for a lower interest rate on their loan. Saving even a fraction of a percentage point could save thousands of dollars over the life of a loan, so if your credit history has room for improvement, it may be worth your while to improve your credit score before purchasing a home.

2.       Loan-to-Value Ratio
During the approval process, the lender will calculate the loan-to-value (LTV) ratio, which is a percentage calculated by dividing the amount you are borrowing by the total value of the home. For example, if you are borrowing $240,000 to purchase a $300,000 home, your LTV ratio is $240,000/$300,000 = 80%.

In general, higher LTVs (usually greater than 80%) are viewed as riskier because the lender is less likely to recoup all its money through the foreclosure/repossession process should the borrower default on the loan. Higher interest rates are charged to higher LTVs to help offset the risk.

Lower LTVs (80% and below) are considered less risky because the borrower is putting more money down and the lender has less to recoup if the borrower defaults on the loan. Lower LTVs tend to receive lower interest rates because the lender is taking on less risk.

3.       Down Payment Amount
A down payment is the portion of the purchase you will pay upfront when you close on your mortgage. How much you put down directly impacts the total cost of homeownership because it impacts the principal loan amount, whether or not you will have to purchase mortgage insurance, and the interest rate. The more you put down on your home, the lower your loan-to-value ratio, and the lower your interest rate may also be.

4.       Debt-to-Income Ratio
When you apply for a mortgage loan, you must prove you are able to fulfill your current debt obligations, in addition to the cost of the proposed monthly mortgage payment. To determine this, your debt-to-income (DTI) ratio is calculated. Simply put, DTI is the total of your monthly debts divided by your gross monthly income. Ideally your DTI should be around 45%, or lower. Lenders will typically offer lower rates for borrowers with a lower DTI.

Here is a simple example of how to determine DTI: If your monthly income is $4,000 and you pay a monthly auto loan of $500 and a student loan of $100, 15% of your gross pay is tied up in debt. As a result, your house payment should not exceed 30% of your monthly income, or $1,200.

5.       Occupancy
On your mortgage application you will indicate the intended occupancy type, and this will impact your mortgage rate. There are three main occupancy types – Primary Residence, Secondary Residence, and Investment Property. A Primary Residence is where you and your family will reside most of the time (at least six months per year). A Secondary Residence is usually purchased to be occupied for a portion of the year (think vacation home), although it must also be suitable for year-round residency. An Investment Property is purchased with the intent of making a profit through renting and/or future resale.

A Primary Residence is viewed as less risky because borrowers tend to make payments on their primary home first, should they experience financial hardship. An Investment Property is considered riskier because in times of financial hardship, borrowers are historically more likely to stop paying on their Investment Property as opposed to their Primary Residence. Secondary Residences fall somewhere in the middle of the occupancy risk spectrum. Although there are exceptions, lenders typically offer lower interest rates on a loan for a Primary Residence, slightly higher rates for Secondary Residences and the highest rates for Investment Properties.

6.       Amount of Mortgage Loan
When buying a home, you’ll find there are different financing options. While most buyers will take the FHA loan, VA Loan or conforming, conventional loan route, there are cases when you may need to consider a jumbo loan for financing.

A jumbo loan is necessary when the purchase price of your property exceeds the current conforming loan limits. As of January 1, 2024, that limit is $766,550. Most financial institutions offer jumbo loans, but they can come with more stringent qualification guidelines and potentially higher interest rates.

7.       Term of Mortgage Loan
mortgage term refers to how long it will take to repay the money you borrow to purchase a home. The most common terms are 15-, 20- or 30-year FHA, VA, conforming or conventional loans with fixed interest rates. In general, the longer the term of your loan, the higher your interest rate because a borrower is more likely to either default over time or pay the loan off early. Both scenarios reduce the lender’s profit from your loan so higher interest rates can help mitigate the financial risk and downside.

An adjustable-rate mortgage (ARM) is a loan with an interest rate that changes over time. The introductory interest rate associated with an ARM is typically lower that the current rate offered on a conventional loan and remains in effect for a fixed term, which is typically 3, 5, 7, or 10 years. After the introductory period ends, the interest rate on your loan may change, depending upon mortgage rates at the time. For instance, if rates have risen since you took out your original ARM, you can expect the interest on your loan to do the same. However, if mortgage rates have fallen, you’ll likely enjoy a reduction in the interest associated with your loan.

8.       Home Location
Believe it or not, the city or state you live in can impact your mortgage interest rate. That’s because local economies can vary widely from one another. In areas with weak economies (high unemployment, weak housing market, etc.), homeowners may be more likely to default on their mortgage. In this case, lenders will charge higher interest rates to compensate for the risk they are taking. In areas with stronger local economies (low unemployment, strong housing market, etc.) lenders consider the loans safer and are more likely to offer lower rates.

Other factors that vary by state and can impact mortgage rates include foreclosure laws, whether it is a recourse or non-recourse state, and lender competition.

If you are shopping for a home in an area that could adversely impact your interest rate, consider exploring spots nearby that may require a few extra commuter minutes but could save on the interest on your mortgage.

Many variables go into determining the interest rate charged on your mortgage. However, with a little bit of planning and strategizing, there are factors within your control. If you have questions about the homebuying process, an FNBO Mortgage Loan Officer can help by offering their expertise and presenting all of your borrowing options.  

The articles in this blog are for informational purposes only and not intended to provide specific advice or recommendations. When making decisions about your financial situation, consult a financial professional for advice. Articles are not regularly updated, and information may become outdated.