How Your Mortgage Rate is Calculated (and What You Can Do About It)
January 17, 2020
When buying a home, you’ll want to shop around for the best mortgage you can get. This not only means finding a lender you trust and the loan that meets your specific needs, but also getting approved for the lowest mortgage rate possible.
Unless you recognize the factors that go into calculating your personal mortgage rate, however, it can be difficult for you to find the best one. And failing to do so can mean tens of thousands of extra dollars over the course of your home’s repayment.
Let’s take a look at what your lender will use to determine the mortgage rate you’re offered, and what you can do to ensure that you get the lowest rate possible.
Why Mortgage Rates Matter
If you’re like most homebuyers, there are three mortgage factors that probably concern you most: the closing costs, the monthly payment, and the rate.
The lower your mortgage rate, the less you’ll spend on your home as you pay back your loan. The savings can be significant, too — on a $250,000 mortgage, a mere 0.25% rate reduction could save you nearly $13,000. Knock that rate down by half a percent, and you’re saving over $25,500 on your home.
Looking at these numbers, it’s easy to see why your mortgage rate matters. But how can you affect the rates you’re offered by lenders?
Well overall, there are two categories of factors when it comes to determining your mortgage rate: what the market looks like and how much risk you pose as a borrower. While some of these are beyond your control, there are some factors that you can directly influence.
And by doing so, you stand ready to save serious cash.
The Factors You Can’t Control
First, let’s talk about the factors that you cannot do anything about. While they will inevitably impact your mortgage rates, you may take some solace in knowing that everyone around you is in the same boat.
Federal Interest Rate Trends
While the Federal Reserve doesn’t actually set mortgage interest rates, it does determine the federal funds rate. This rate is used as a benchmark for many other interest-based products provided by banks around the country… including mortgages.
If the Fed lowers the federal funds rate, you can usually expect mortgage rates to (overall) following. If their rate goes up, though? Expect mortgages to trend in the same direction.
You may not realize it, but inflation has a direct, cyclical relationship with mortgage rates. As inflation climbs, so do mortgage rates. As mortgage rates climb, inflation is further affected.
It’s an unfortunate feedback loop, but also one that you cannot control in any way.
To be fair, you have some control over the area in which you are buying. But while it’s easy to buy in the next city or county over, moving to another state is a whole different animal.
Mortgage lenders may offer slightly different rates from one state to the next, due to things like foreclosure laws and differences in population. If your job, family, etc. limits your ability (or desire) to move to another state, you’re simply stuck dealing with those impacts.
The Factors You Can Control
Now, on to the things that you have some say over. These factors are all considered by mortgage lenders when underwriting your new loan and determining the rate for which you qualify.
Improving some or all of them can have a significant impact on the mortgage rate you’re offered.
A high credit score is associated with better creditworthiness. Creditworthy borrowers are considered to be a lower risk to lenders, enabling them to qualify for lower mortgage interest rates.
By improving your credit score in the years leading up to your mortgage application, you can seriously reduce the rates you’re likely to be offered.
Debt-to-Income (DTI) Ratio
Mortgage lenders typically want a borrower with a debt-to-income ratio, or DTI, of 36% or less. While your unique lenders may have their own preferences, you can rest assured that a high DTI will signal risk to banks… which equates to a higher mortgage rate.
Plus, a DTI higher than 43% will almost always mean mortgage loan denial.
Expensive homes (those with a price tag exceeding FHA conforming limits) often require what’s called a jumbo mortgage loan. The threshold for this loan varies by area, but is currently at $484,350 for most of the country.
Taking out a jumbo loan often means higher mortgage rates and higher down payment requirements.
Loan-to-Value (LTV) Ratio of Your Home
Your home’s value versus your actual loan amount is called its LTV, or loan-to-value, ratio. This can be lowered by buying a home below market value and/or providing a higher down payment.
The higher this ratio, the more risk your lender is taking on. And the more risk you ask them to take on, the higher your mortgage rate is likely to be in return.
Mortgage Loan Term
Lastly, you can expect banks to offer different interest rates based on the loan terms you choose. For example, 15-year mortgages tend to have lower rates than 30-year mortgages, and variable interest rate loans tend to have lower rates than their fixed, predictable counterparts.
You cannot completely control the mortgage rates you are offered when shopping around for a new home. There are many variables at play regarding the market, your state, and even the U.S. dollar.
However, there are many factors that you can control. By working to improve things like your credit score and debt burden before shopping for a new home, or choosing the down payment and loan terms that your lender prefers, you can often lower your mortgage rate by a significant amount.
Even dropping your rate a quarter of a percent can save you tens of thousands over the years. It’s easy to see why finding ways to lower your mortgage rate is well worth the effort!