By Peter Norden
Numerous factors affect your mortgage rate. Not all are intuitive. If you’re in the market for a new house, you’ll need to know what to expect when you start shopping for loans—and how to avoid sticker shock.
These eight factors are all very important. How many are on your radar?
1. Your Credit Score
Many prospective homebuyers assume that credit score is a make-or-break factor for lenders. That’s not exactly true—“make-or-break” is a strong term. But it’s undeniable that excellent credit is a strong positive for lenders wary about prospective buyers’ abilities to repay their loans.
Before you apply for a mortgage, get at least one credit report at AnnualCreditReport.com, a completely free service authorized by federal law. If you’re disappointed by your score, don’t give up. Instead, put off home shopping for another season and take meaningful steps to improve your score, like reducing your debt-to-income ratio (see below).
2. Your Debt-to-Income Ratio
Your debt-to-income ratio plots your gross monthly debt obligations against your gross monthly income. The higher the ratio, the higher your loan rate is likely to be. (If your ratio is too high, you may not qualify for a loan at all.) Paying down debt over time is the only sure way to reduce your debt-to-income ratio.
3. Where You’re Buying
Location matters. Mortgage rates vary slightly by state, so it’s crucial to check prevailing rates in your area rather than rely on national averages. Rates vary somewhat more significantly along the urban-rural divide. Some lenders avoid working in rural areas altogether, so you’ll need to cultivate relationships with local banks (or seek out national lenders that play in rural areas) to get the best rate. The upshot: Many rural buyers qualify for USDA loans, which aren’t available to city slickers.
4. Your Loan Size
Size matters too. Every market is different, but larger loans sometimes carry higher interest rates than average-size loans. Same goes for below-average-size loans, though smaller loans’ monthly payments are likely to be more manageable for most buyers. At the market’s extremes, mortgage calculators tend to be less effective. Again: When in doubt, go directly to the lender.
5. Your Down Payment
Your down payment influences your loan size, which in turn affects your mortgage rate, but it’s also important in its own right. As a general rule of thumb, larger down payments lead to more favorable loan terms—including lower rates. On the other hand, putting 20 percent down is easier said than done, especially for younger buyers in pricey coastal markets (and buyers of modest means anywhere). If you’re committed to getting the best possible rate on your loan, it may be worth your while to wait until you can afford a larger down payment, even if it means putting a hold on home shopping for now.
6. The Loan Term
All other factors being equal, longer loan terms mean higher rates. Many buyers opt for 30-year terms, the longest available to most borrowers. If you’re looking at shorter-term loans—15 years is common—then you’ll likely catch a substantial break on your rate. The catch: Due to the shorter term, your monthly payments will likely be higher, even though you’ll pay less interest over the full term of the loan. If protecting your monthly cash flow is important, a longer-term, higher-rate loan may still be the best choice.
7. The Loan Type
Certain borrowers qualify for special loan types that aren’t available to the general public. For instance, VA loans are available only to current and former servicemembers, FHA loans are designed for borrowers with lower credit scores, and USDA loans (mentioned above) are reserved for rural residents of modest means. Each loan type has its own set of features and restrictions that may (or may not) affect rates.
8. The Loan’s Rate Structure
Novice buyers may assume that all mortgage loan rates are fixed, but that’s decidedly not the case. Adjustable-rate loans typically have lower starting rates than fixed-rate loans. That’s good news in the short term. But adjustable-rate loan rates can adjust upward, sometimes significantly, after a set period of time. Adjustable-rate loans typically make more sense for homebuyers who plan to refinance or sell relatively soon after buying. To determine which rate structure makes more sense for your needs, use a mortgage calculator.
Bio: Peter Norden leads HomeBridge Financial Services, Inc., a leading residential mortgage lender based in New Jersey.