How do mortgage rates work? What you can do to get the best rates
April 5, 2020 • 5 min read
What we'll cover
How mortgage rates work
Different mortgage and rate options
How to get the best mortgage rates
What's at the top of your list of home-buying wants? Sure, the right number of bedrooms and bathrooms is important. But getting a good interest rate is probably a priority, too.
Whether you’re getting a new home loan or looking to refinance, mortgage lending details and practices can be confusing. (Especially if you’re a first-time homebuyer.) Here are answers to questions you may have about how mortgage rates work, how they are determined, and what you can do to get the best rates.
How do mortgage rates work?
Mortgage rates work much the same way that other types of loan interest rates work. A lender charges you a certain percentage of the principal you borrow over time. In the case of a mortgage, the principal is the amount you need to borrow to purchase the home.
Put another way, mortgage rates indicate the cost of the credit extended to you. The lower the rate, the lower the cost of borrowing and the less you pay over the life of your home loan.
How is your mortgage rate determined?
Mortgage rates are determined by several factors. You likely know that your credit score has a lot to do with the rates you may qualify for. But lenders also consider things like the type of loan you choose, how much you put down upfront, and the current rate environment to determine your mortgage rate.
Different types of mortgages offer different rates.
Fixed-rate and adjustable rate mortgages (ARMs) are the two main types of home loans, and the rates available will vary depending on which type you choose.
A fixed-rate mortgage allows you to lock in the same interest rate for the life of the loan.
Adjustable-rate mortgages (ARMs) offer a fixed rate for a set period of time, like five, seven, or 10 years. After that period, the loan will have a variable rate, which fluctuates according to market conditions.
ARMs typically offer lower fixed rates at the outset, but fixed-rate mortgages offer predictability over the long term.
A jumbo loanis another type of mortgage that allows borrowers to take out a loan for more than the federally-determined conforming loan limit. Rates for jumbo loans can sometimes be lower than traditional mortgages.
Condo or vacation home? The property type matters, too.
Are you looking to finance a rental property? Move into a larger home for your growing family? The type of property you use the loan for affects the mortgage rate you can get. For example, mortgage rates for second homes or investment properties are typically higher than those for primary residences. Be sure you’re comparing mortgage rates for the same type of properties as you shop for loans.
How can you get the best rates?
You can’t control the economy. But there are things you can do to make sure you’re getting the best mortgage rates possible.
Take care of your credit score. No surprises here. Your credit score helps lenders evaluate your ability to pay back your loans, based on your borrowing history. That’s why your credit score has a direct impact on the rates you qualify for. The higher your score, the better the rates you’ll be able to get, which can lead to significant savings over the life of your mortgage.
Shop and compare. Mortgage rates, interest rates, annual percentage rates — that’s a lot of rates. The truth is, those numbers aren’t necessarily interchangeable. While comparing interest rates is a good start, they only tell part of the story. What you really want to know is the annual percentage rate (APR) on any loan you consider. Compared to interest rates, the APR gives you a more complete picture of the true cost of borrowing. That’s because it includes, not only your interest rate, but also any points, fees, closing costs, and other charges rolled into your loan over the course of one year.
Make a sizeable down payment. Your down payment is the amount you pay up front on the loan. The size of your down payment can affect your mortgage rate. Typically, the larger the down payment, the lower the rate. But the exact impact of your down payment depends on your unique financial scenario. A typical down payment is 20% of the total loan amount, but paying more or less will affect your monthly mortgage payment amount. You can plug your numbers into a mortgage calculator to see how different down payment scenarios affect your monthly payment.
Pay down mortgage points. Depending on your lender, you may be able to “buy” a lower rate by prepaying some of the interest, called “points.” The more points you buy, the lower the interest rate on the loan.
While buying a lower rate may seem appealing, keep in mind that depending on how soon you sell or refinance your home, it may not be worth the expense.
Lenders have the final say.
At the end of the day, the terms of any home loan are up to the lender extending the credit. Each lender will take the above factors into account and determine the rates and terms to offer. Individual lenders also decide how much to charge in lender fees, closing costs, and so on.
To properly compare apples to apples, get a loan estimate for each loan you consider. A loan estimate will include all closing costs, including lender origination fees and an estimate of required third-party fees like title, appraisal, recording fees, and taxes.
Now that you have a better understanding of how mortgage rates are determined (and steps you can take to help get a better rate), buying a home with your dream bed to bath ratio will just be icing on the cake.