If you’re planning to buy a home in the near future, you’ll want to get the lowest interest rate possible on your mortgage. Even the difference of a fraction of a percent can save you tens of thousands of dollars over the life of your home loan.
That’s why it’s important for you to understand all the factors that impact the rate you’re offered. With this information on hand, you’ll be better able to ask lenders the right questions and understand all your options before choosing a mortgage.
Here are 8 things that influence your mortgage interest rate.
1. Your Credit Score
Your credit score is a critical component of your overall financial health and gives lenders a good indication of the type of borrower that you would be. Not only is it helpful for lenders to assess the interest you’d get on your mortgage, it’s also used in just about every other type of loan you would take out.
Lenders want to be sure that the borrowers they loan money to are financially capable of paying back what they owe in full and on time every month. One of the ways they do that is by determining what your credit score is, which is a reflection of your payment history.
Credit scores and mortgage interest rates are typically inversely related: generally speaking, the higher your credit score, the lower the interest rate, and vice versa.
Before getting pre-approved for a mortgage and shopping around for a home, it would be wise to pull your credit report to find out exactly what your score is and take steps to improve it as necessary. You could save yourself a lot of money with a lower interest rate by making an effort to increase your credit score.
2. Loan Amount
The amount of money that you will need to borrow from your lender can impact the type of interest rate you are offered. Usually, a very high loan amount tends to come with a higher interest rate. That’s because lenders are being placed at a higher level of risk when providing large loan amounts.
On the other hand, very small loan amounts can also increase the mortgage interest rate because lenders want to be able to make a decent profit.
Generally speaking, loans for less than $100,000 and more than $417,000 are typically charged higher interest rates compared to loan amounts that fall somewhere within that range.
3. Down Payment
Since your down payment directly affects your loan amount, it will also play a role in the interest rate you’re offered. Borrowers who are able to put a higher down payment on a home towards the purchase price are generally seen as a lower risk, while very small down payment amounts place more risk on the lender.
A bigger down payment helps to reduce your loan-to-value (LTV) ratio, which is the relationship between your loan amount and the value of the property. However, a smaller down payment increases the LTV, placing more risk on the lender, and therefore increasing the interest rate.
4. Loan Type
There are several different types of mortgages available, each of which will come with slightly different interest rates. In fact, rates can vary a great deal depending on the loan type. For instance, FHA loans (those backed by the Federal Housing Administration) often offer lower interest rates compared to conventional loans. That said, FHA loans usually also require borrowers to pay for private mortgage insurance (PMI) given the much lower down payment requirements.
It’s helpful to speak with a mortgage specialist in order to understand all the mortgage types available and the interest rates that usually come with them.
5. Mortgage Term
The mortgage term is the length of time that a borrower is committed to the lender, as well as the conditions of the mortgage and the interest rate associated with it. The term has a direct influence on the mortgage interest rate: generally speaking, shorter loan terms come with lower interest rates compared to longer terms. Once the term comes to an end, the mortgage is renewed at a different mortgage rate.
Short loan terms are those that are less than three years in duration. Borrowers often choose this route if they believe interest rates are on their way down and hope to secure a lower rate when they renew.
On the other hand, long loan terms are those that are more than three years in duration. Borrowers exchange a higher interest rate for more security in the form of locking in a specific rate for a longer period of time, especially if it’s believed that rates will rise in the near future.
6. Fixed Vs. Adjustable Rate
Mortgage interest rates can either be fixed or adjustable. As the named suggests, “fixed” rates are those that do not change over the term of the loan. Borrowers lock in at a specific rate and pay that same rate without having to worry about it changing, even if the posted rate does. Since the total payment amount stays the same throughout the term, budgeting is much easier for borrowers with fixed rates.
Adjustable rates, however, fluctuate throughout the loan term based on the market. They tend to be lower at the beginning of a mortgage compared to fixed rates, but these rates can increase a great deal in the near future. If the adjustable-rate mortgage is held for a long time, the rate can be higher than that of fixed-rate mortgages.
7. Whether “Discount Points” Are Purchased
In an effort to get a lower interest rate on a mortgage, borrowers have the option to “buy down” their interest rate by purchasing “discount points.” Paying more money upfront at closing can help reduce the interest rate in an effort to cut back on the overall interest costs over the life of the mortgage.
Essentially, a discount point is a type of interest that’s prepaid, whereby one point is equivalent to 1% of the mortgage amount. Borrowers basically exchange a lump sum of money upfront for a lower rate.
8. Location of the Property
Where your home is located can impact your interest rate. For instance, some lenders may offer different rates for properties located in rural areas compared to those located in urban centers.
The Bottom Line
Knowing what influences your mortgage rate will help you make the right decisions when it’s time to choose a lender and pick a mortgage. Anything you can do to secure a lower rate can help you save a ton of money over the life of your loan, and that all starts with a sound understanding of interest rates and the factors that affect them.