February 19, 2018

How do mortgage rates work and what determines your rate?

How do mortgage rates work

Want to know a little secret about getting the lowest mortgage rate?

Spending hours shopping online mortgage rates, filling out lots of online applications, and then trying to sort through hundreds of phone calls from eager loan officers is a complete waste of everyone’s time! That’s not how mortgage rates work.

Every one of those websites and loan officers offer the same rates. Truth is “the market” and the economic factors that move Wall Street determine the mortgage rates lender can offer. But, the mortgage rate that you get from the lender is all about you, not them.

Thinking about buying a new home? Use our home purchase calculator to see what you qualify for and start your loan application with confidence.

What factors determine the rate someone will receive on their mortgage?

I’m going to take you behind the curtain to reveal the real wizardry behind mortgage rates.

The interest rate you get for your mortgage is slightly higher or lower depending on how likely the lender thinks you are to repay them in full. There are several factors that they will evaluate to make this determination and set your rate. Here are a few the key factors, in order of what typically creates the biggest adjustments, up or down.

    1. The goals you communicate to your loan officer. If you tell your loan office that you want the lowest closing costs, then they will “buy up” or increase your mortgage rate, to give you more “credit” in the rate, to cover closing costs and fees. Costs and fees, most of which are out of their control and baked into the loan, i.e., title, recording, and prepaids. If you tell them you want the lowest rate, then they will “buy down” or reduce your interest rate, which will remove those credits and therefore more of those closing costs and fees will be paid by you directly, upfront and not financed into the mortgage. Ironically, most of the variance I see in loan estimates that I compare is because the customer conveyed different goals to different lenders or the loan officer was inexperience or just not listening. Not because one lender had a lower rate to offer.
    2. Loan products: Home Possible, Home Ready, VA, FHA, USDA, and Conventional loans all have different price features that adjust the mortgage rate higher or lower. This is primarily because they are designed to assist home affordability for particular types of borrower groups.
    3. Credit score: This is the one most people focus on, but like all other factors it’s just one adjustment of several and not necessarily the biggest.
    4. Loan-to-Value (LTV): The loan amount to be financed as compared to the appraised value of the home. This is a function of the amount of downpayment you’re putting down on a new purchase or the amount of equity you have in a refinance scenario. Therefore, if you put 20% down or have 20% in equity, then your interest will be lower than if you put the minimum of 3 or 3.5%. By putting more money down, your shifting more of the risk to yourself as the borrower (“skin in the game”).
    5. Debt-to-income (DTI): The amount of debt you are required to pay (service) each month in relation to your monthly gross income. The lower this ratio, the more margin you have to make sure you pay your mortgage. For example, if you have two credit cards with a minimum monthly payment of $500/month on each and a car payment of $400/month and you make $6,000 per month, then your debt-to-income ratio is ($500+$500+$400)/$6000 = 23%, before your housing payment. If you then add in a $1,200/month mortgage payment that ratio rises to 43%. The best rates will go to folks with a before housing ratio of less than 35% and with housing ratio of less than 45%.
Thinking about buying a new home? Use our home purchase calculator to see what you qualify for and start your loan application with confidence.

As I mentioned before, it’s a really important thing to remember that mortgage rates are market driven and therefore there isn’t much difference from lender to lender. Your goals and credit profile, along with how the loan officer interprets your stated goals makes the biggest difference in the rate you get quoted from a lender.

So, if it’s not about interest rates, what should I consider when choosing a mortgage lender?

Experience and knowledge

Selecting the right loan and understanding how to meet the goals of the borrower can become complicated. People’s financial situations are often messy. If you get a loan officer that hasn’t experienced a lot of scenarios or doesn’t understand the products they have available, you could end up with a really expensive loan or be disqualified unnecessarily.

Unfortunately, a high percentage of loan officers don’t and have never actually owned a home. This inexperience can cost you tens of thousands of dollars over the life of your mortgage loan.

Available loan products

Make sure your lender or mortgage broker has access to all of the available products on the market. Here are just a few common examples:

  • If you’re a veteran, you don’t want to get a higher rate just because the lender can’t do VA loans and sticks you in a Conventional loan
  • Told you’re not qualified just because they can’t do FHA loans, or
  • Get a higher rate and pay more as a first-time home buyer because they don’t have Home Possible
Thinking about buying a new home? Use our home purchase calculator to see what you qualify for and start your loan application with confidence.

Why is it important for the lender you chose to have government loans, like FHA, VA, and USDA?

FHA, VA, USDA, are government loans that are designed to increase home affordability for certain categories of borrowers and home buyers. Because they are attempting to increase the access to homeownership for these groups of people, they are typically best for folks that have a little less to put down, tend to be on the lower end of the credit spectrum, or have a little higher debt-to-income.

If you are a first-time homebuyer or qualify for these type of mortgages, they can be a big benefit and save you a lot of money. You certainly don’t want to get turned down or pay thousands more just because the lender you go with does have these types of loan programs.

Be aware of mortgage insurance… and what it is?

Mortgage insurance is not necessarily a factor in your mortgage rate, but it will be a significant factor in your monthly payment and the total cost of your mortgage.

Mortgage insurance is one of those good and bad things. For people that have less than 20% to put as a downpayment (almost everyone), it helps to get qualified, but you want to know how to get rid of it as soon as you can. Here’s why.

Mortgage insurance is 100% to the benefit of the lender. Mortgage insurance is insuring the lender against your non-repayment of the loan. It’s a great feature because it allows most borrowers to buy a home with less than 20% or get an FHA loan when you have a bit weaker credit profile, but over the long-term, you should work toward paying down their loan and removing this insurance. After all, the insurance you’re footing the bill for is for the sole benefit of the lender.

Questions? Comments? Talk to me on Twitter @billrice and please include a link to this article for my reference.

Thinking about buying a new home? Use our home purchase calculator to see what you qualify for and start your loan application with confidence.

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