What affects the interest rate I receive on a mortgage or home loan?
There are a number of variables that are used to compute the interest rate on a home mortgage. Credit score, debt-to-income ratio, down-payment amount, mortgage type, and points all determine the interest rate you will receive on a home loan.
The current market conditions
Mortgage interest rates are directly impacted by the prime interest rate. As the prime rate rises and falls, so do mortgage rates.
Loan duration
Typically, shorter term loans will have a lower interest rate than longer term loans. For example, 15-year Fixed Rate Mortgages usually have a lower interest rate than a 30-year Fixed Rate Mortgage.
Credit quality and debt-to-income ratio
Your credit quality and debt-to-income ratio affect your mortgage interest through your FICO Score. If you have good credit and your monthly income far surpasses your monthly debt obligations, you should get approved at a lower mortgage interest rate.
However, if your monthly income barely covers your minimum debt obligations, even if you have a good credit report, you will likely not receive the lowest available interest rate on your home loan.
Amount of the down payment
A down payment larger than 20% will give you the best possible mortgage rate. With a down payment of 5% or less, you should expect to pay a higher rate as you are starting with less equity as collateral.
Points
If you've got the cash now and want to lower your mortgage payments, you can pay points on your loan to lower your mortgage rate. In exchange for more money up front, lenders are willing to lower the interest rate they charge, cutting the borrower's payments. Closing costs are fees paid by the lender, if you do not want to pay all of the closing costs, expect a higher mortgage rate which will pay the lender additional interest over the life of the loan. In laymen's terms, you either pay now or pay later.
A point is 1% of the total home loan amount. Paying money up-front, via points, reduces your monthly interest rate and total interest due over the life of a loan. Generally speaking, a one point loan will always have a lower interest rate than a 0 point (or no-point) loan.
Whether or not you should pay points depends on how long you are looking to keep the home loan. If you plan on keeping your home for at least 4 years, then paying points may be a good decision. However, if you move before 4 years, you likely won't have enough time to recover the point costs through lower monthly payments.
Lenders allow you to choose from a variety of rates and point combinations for the same loan product. When comparing rates from different lenders, make sure you compare the points and rate combinations of the programs. The mortgage annual percentage rate, or APR is a tool used to compare different terms, offered rates, and points among different lenders and programs.