While exciting, buying a home can feel a bit overwhelming at times. After all, there are many questions that you want answered. How much can I afford? Will the property taxes increase next year? Should I avoid a house that’s part of a homeowners association?
And let’s not forget one of the most important questions: What will my interest rate be?
Your interest rate helps determine the amount of your monthly payments, how fast you’ll be able pay off the mortgage, and even whether or not you’re better off buying now or waiting and continuing to rent.
Average mortgage interest rates are always available from banks, but those figures aren’t the rate you’ll actually receive on your home loan. It’s only after a lender has all of your personal information in-hand that you’ll find out exactly how much your interest rate will be.
Read on to learn more about why interest rates vary so much and the circumstances that influence them.
Factors That Determine Your Interest Rate
Hands down, one of the biggest factors that affects your interest rate is your credit score, which is the cumulative result of your credit history and how you’ve handled loans or debt in the past. Borrowers who consistently pay their monthly credit cards and other loan payments on time will likely have a high credit score, whereas a consumer with a less consistent record will likely have a low one.
Those with higher credit scores are oftentimes eligible for lower interest rates because they’ve proven themselves to be trustworthy borrowers in the past.
Specifically, a lender will look at your FICO credit score from each of the three major credit bureaus — Equifax, Experian, and TransUnion — and calculate the average of those figures. Credit scores range from 300 to 850, with a score of 750 or over deemed “excellent.”
Conventional mortgages, which aren’t backed by any government agency and usually have fixed terms and rates, typically require borrowers to have a minimum credit score of 620. Borrowers with lower credit scores (500 or more) can usually qualify for FHA loans that are insured by the Federal Housing Administration.
TIP: If your credit score isn’t in the best shape, don’t worry too much! You can improve your credit over time with some relatively easy fixes.
Another component that lenders use to determine your interest rate is your debt-to-income ratio (DTI) or how your monthly debt payments compare to your monthly gross income. Many lenders prefer a DTI of 43 percent or less. Why? Borrowers with fewer financial obligations are less likely to default on a loan.
When calculating your DTI, all debt counts, including your new mortgage payment plus car loans, student loans, medical debt, credit card debt, personal loans, and business loans you’ve personally guaranteed.
Those with a low DTI and a significant history of making on-time payments are often rewarded with a better interest rate than borrowers who have carried, say, large amounts of credit-card debt for a long period of time or been late with their payments repeatedly. Lenders view these applicants as less likely to repay their mortgage as promised.
Type of Loan
The type of loan you apply for can also affect your mortgage rate. FHA loans usually have higher interest rates than conventional loans since lenders offer them to borrowers with lower credit scores.
Adjustable-rate mortgages (ARMs) and fixed-rate mortgages also come with different rate schedules. An ARM typically charges a lower interest rate to start with than a fixed-rate loan, but that rate could change throughout the life of the mortgage.
The length of your loan also impacts its interest rate. Thirty-year loans have higher rates than 10- or 15-year mortgages. The difference can be as much as 1 percent more for a 30-year loan.
The Amount of Your Mortgage
How much you borrow will also determine how much you’ll pay in interest. The more you put down, the lower your rate could be. A hefty down payment not only helps to prove your creditworthiness to a lender, but also gives you more equity in the home. Putting down three or five percent will likely lead to a higher interest rate than if you make a down payment of 10 or 20 percent.
Where You Live
The city and state where you reside can have an effect on the interest rate you’ll qualify for. In general, cities and states with a higher cost-of-living have higher interest rates. So don’t be surprised if you live in California and find out that your cousin in Kansas has a lower interest rate on a similar mortgage.
If interest rates are higher where you live, combat that by researching lenders to find the best rate possible.
Happenings around the world that impact the U.S. economy, like political instability or even a sluggish housing market here at home, can cause interest rates to fluctuate. Mortgage rates can change every single day — or even several times in a single day.
Every time the Federal Reserve raises or lowers its benchmark interest rate, mortgage lenders tend to follow suit and charge higher (or lower) rates to prospective customers. In 2016, the average rate on a 30-year fixed mortgage was 3.65 percent. By 2017, the average rose to 3.99 percent, largely because the Fed raised interest rates three times in 2017 to account for the rebounding economy.
While interest rates have increased in recent years from historic lows, be glad you weren’t applying for a mortgage 40 years ago. Back in the 1970s and 80s, interest rates for 30-year home loans ranged from 8 to 16 percent.
The House You Buy
That’s right, you could land a lower interest rate simply because you’re purchasing a new townhouse instead of a 120-year-old, two-story Tudor. Lenders examine the historical data of various property types (single family, condo, duplex, etc). in your area, as well as the state of the home itself and the amount you’re wanting to borrow against it. The interest rate is all about striking a balance between the amount of money a borrower needs and what they can reasonably be expected to pay off over the length of the mortgage given all of these factors.
As you can see, a lot goes into answering the question, “What will my interest rate be?” It’s not just your creditworthiness, but factors determined by the lender and the broader mortgage market that matter, too.
What’s the number you’re hoping to hear from your lender?