It’s no secret that a lower interest rate can mean significant savings over the life of your mortgage. Although interest rates are largely dictated by market performance, there are other factors that influence the rate you receive. When comparing your loan options, it helps to know how your interest rate was derived and what mistakes to avoid when shopping around.
In addition to market performance, home loan interest rates are influenced by six major factors: loan amount, loan type, loan duration, discount points, closing costs, and credit score.
1. Loan Amount
Contrary to what you might assume, very low loans are often as risky in the lender’s eyes as very high loans. Processing, funding, and underwriting a loan costs lenders a minimum amount of money, regardless of the loan size. To account for this operation cost, they charge borrowers a percentage of the loan amount in what’s known as “origination fees” or surcharges. Because the profit margin on a smaller loan is already low, point surcharges on lower loans must be higher to protect the lender from forfeiting money. By raising the mortgage rate on the loan, the lender accounts for these costs without requiring the borrower to pay the surcharge fee up front. So, what does all that mean for you as a borrower? In short, it means that a very small loan might still have high fees attached.
At the other extreme, exorbitantly high loans (or “jumbo” loans) offer banks a larger potential profit margin, but present significantly greater risk. Due to their sheer size, these loans are harder to fund and sell, and ultimately cost the lender more to execute. For this reason, very large loans also have high interest rates to mitigate the inherent cost and risk to the lender. In other words, if your loan is too large, it could inflate your interest rate.
When comparing interest rates based on loan amount, keep in mind that low and high are relative terms. What may be a low interest rate for a $200,000 loan is significantly higher for a $600,000 loan. In addition, interest rate changes of a fraction of a percent are more significant when the loan value is greater. Do the math to make sure you understand the long- and short-term cost of your interest rate.
2. Loan Type
With regards to conventional loans, there are two main varieties to consider: fixed-rate mortgages and adjustable rate mortgages, or ARMs. As you shop for a home loan, here’s the basics you should know:
Fixed-rate mortgages, like the name suggests, offer the borrower the same interest rate for the duration of their mortgage. ARMs, on the other hand, often start out at a low fixed-rate but are later adjusted at regular intervals based on market conditions. Though ARMs often begin lower, they are naturally more volatile because interest rates will change periodically and alter your recurring costs. In comparison, fixed-rate mortgages are usually higher, but offer greater stability and predictability. As federal interest rates and rent prices continue to climb, many people are looking to lock-in a fixed-rate mortgage and make smarter investment decisions.
3. Loan Duration
A shorter loan term poses less risk to the lender, which is recognized with a lower interest rate. Longer loans ask the lender to shoulder more risk and typically have higher interest rates. Though a lower interest rate seems like the optimal choice, it’s important to remember that a shorter mortgage means that the buyer must pay more per payment as opposed to making smaller payments over a longer duration. If that explanation is making your head spin, you’re not alone. Don’t be afraid to enlist the help of an expert to help you with the following calculations and considerations:
To determine which mortgage length fits your budget and long-term goals, compare the short-term quality of living costs (i.e. if you can afford to make higher mortgage payments and maintain your desired lifestyle) against the long-term interest costs (i.e. how much additional interest you’ll pay over the course of a longer-term mortgage in comparison to a short-term mortgage).
4. Discount Points
You may have heard of mortgage points before—here’s where they come into play. Discount points can be purchased from the lender at the time of closing to lower the interest rate on your mortgage. A single point costs one percent of your mortgage total and reduces the cost of your recurring payments. Buying points ultimately equates to paying interest up front—a strategy that has greater potential savings with longer loan durations. Similar to putting more money down, if you can afford to purchase more mortgage points upfront, you’ll save a good chunk of change down the road.
5. Closing Costs
Closing costs vary by state and cover services like loan origination and appraisal, title fees, and insurance premiums. On average, that amounts to a few thousand dollars due at the time of the closing. If, instead, you opt for a no-closing-cost mortgage, your interest rate will increase to cover these initial costs over the lifespan of the loan.
If you don’t have the funds to pay closing costs or plan on selling the home in a short time period, a no-closing-cost mortgage may be an ideal option. That said, if you have the means and plan on sticking out a long-term mortgage, you’ll likely save more by paying closing fees up front.
6. Credit Score
Simply put, the higher your credit score, the lower your interest rate. Individuals with a more turbulent credit history and lower overall score represent a greater risk to the lender. To offset this risk, lower credit scores are met with higher interest rates. Conversely, if you have a good credit history, lenders are more likely to offer lower interest rates that encourage borrowing because they’re statistically more likely to see their loan returned (with interest, of course). If you have less than perfect credit, don’t dismay. You still have lending options.
Interest rates can be influenced by a variety of factors, and determining the best rate can be a balancing act. Knowing what mortgage options are available to you and what factors are impacting your interest rate will help you make the right choice. To enlist the help of an expert and get a clearer picture of your interest rate options, schedule a free mortgage analysis.