Your mortgage interest rate is probably one of the most important factors of your loan. It affects not only your mortgage payment, but how much the loan will cost you over its entire term. Understanding what factors affect your interest rate can help you get the lowest rate possible.
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Your Credit Score is a Major Factor
Your credit score says a lot about you. It lets lenders know your level of financial responsibility. If you have a high credit score, lenders assume that you pay your bills on time and don’t overextend your finances. If you have a lower credit score, lenders assume that you pay your bills late or overextend your credit.
Of course, lenders also look at your credit history, so they can see for themselves what you do with your finances, but your score is one of the first things they notice. A higher credit score typically gets a borrower a lower interest rate. Of course, there are other factors that matter, but the credit score is one of the most influential pieces of the puzzle.
Your Debt Ratio Plays a Role
Another layer in your level of risk is your debt ratio. It lets lenders know your likelihood of defaulting on your mortgage. The more money you already have spent for each month, the less likely it is that you’ll pay your mortgage on time.
There isn’t a specific debt ratio you need across the board, though. Each loan program is different. Some loan programs, such as the conventional loan, require debt ratios as low as 28% on the housing and 36% for a total debt ratio. Other loan programs are more forgiving and don’t automatically increase your interest rate for a higher debt ratio.
Your Loan-to-Value Ratio is Important
How much money you borrow compared to the home’s value also plays a role in your interest rate. The higher your loan-to-value ratio or LTV becomes, the higher the risk the lender takes giving you a loan. What a lender wants is to see you invest your own money into the home.
The more money you invest yourself, the higher your likelihood of making your mortgage payments become. You probably don’t want to take a chance in losing your own money invested, so you’ll do what you can to get the mortgage paid. Now, if you borrowed most of what it took to buy the home, with only a small amount (or none) of your own money invested, you have a higher likelihood of defaulting on the loan. This means that you’ll end up with a higher interest rate to make up for the risk of default.
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What’s the Size of Your Loan?
Putting the home’s value aside, large loan amounts usually have higher interest rates as well. Lenders typically call any loan amount over $484,350 a jumbo loan. These loans have higher interest rates because of the higher risk of default. If you borrow $650,000 versus $484,350, the lender is at risk of losing another $165,650, which can be a huge loss.
Lenders offset this risk by giving you a higher interest rate. They figure that they at least make the money on the interest you pay while you do make your payments. If you end up defaulting, the lender has the satisfaction of making a little money on your loan, which can offset the loss of the money left on the loan.
What’s the Term?
Finally, lenders look at the amount of time that you borrow the money. The longer you borrow money, the more interest they will charge you. Ideally, lenders want you to borrow the money for the least amount of time possible.
For example, if you asked for quotes on a 15-year term and a 30-year term with all other factors remaining equal, lenders are usually going to give you a lower interest rate for the 15-year term. This is because you cut the time in half that it takes to pay the lender back the full amount of the money you borrowed. This means the lender can loan that money out to someone else in half the time and increase their profits.
The bottom line is that your interest rate is based on your risk. The higher your risk of default becomes, the more likely the lender is to give you a higher interest rate. Don’t forget to ask about buying the rate down, though. If a lender quotes you an interest rate that you’d rather not pay, ask if you can buy it down and see what it will cost you. This way you can make an informed decision on the right interest rate for you.
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