You and your new neighbor are comparing details on your new homes, only to find out that despite buying a similar house around the same time, your rates are different. You can’t help but feel slightly bewildered and have questions as to how this could have happened.
It’s not an uncommon scenario. Despite both of you appearing to have similar financial profiles, the nuances related to each family’s unique situation impacts the seven primary factors that are used to calculate your interest rate. Beyond your circumstances, there are market factors that also affect your rate, of course, but in this post we share what factors you can control that may affect the rate being provided by your lender.
Your interest rate is largely determined by risk. Risk, in the eyes of a lender, is calculated based on the likelihood of the full loan they extend being paid back. To understand which factors contribute to more or less risk, lenders use statistical models based on historical loan repayment data. Higher risk loans lead to higher interest rates while lower risk loans lead to lower interest rates. To determine how risky your overall financial profile may be, it’s important to understand the seven key factors that may affect your rate.
Seven Primary Factors Affecting Rates
- Loan Transaction Type (i.e. Purchase or Refinance)
- Credit Score
- Property and Occupancy Type
- Loan Size
- Debt to Income Ratio
Loan Transaction Type
If your neighbor is refinancing their home and you are buying a new property, the transaction type – refinance or purchase – will affect your interest rate. Purchase transactions typically have lower interest rates as they are sometimes eligible for special incentives for home buyers.
If you’re refinancing an existing property, however, your rate would depend on the type of refinance. Often, home buyers may opt to refinance in order to lower their interest rate. However, this is not always the case as there are many refinancing options. Cash-out and no fee refinancing have their own nuances, so it’s important to understand what each one means and choose based on your primary goal.
Your credit score will directly impact your rate. An average credit score is between 670-739, while a 700 and above is considered a good credit score. If your credit score is 800 or above, congratulations, you’re well ahead of the curve. Naturally, a high credit score correlates to a better interest rate and enables you to qualify for premium loan programs since your perceived risk is rather minimal.
A loan-to-value ratio (LTV) is the dollar amount of your loan divided by value of the property. This ratio reflects the percentage of the home that the bank owns, compared to the percentage of the home that you own. The higher amount of your home that you own, known as equity, the lower the risk on the loan. So, the higher down-payment you’re capable of offering, the lower your loan-to-value ratio will be. In other words, as you increase your down payment and equity in the home, your interest rate will decrease.
Conversely, the more money you take out as a loan for your home, the higher the risk you pose. By calculating your loan-to-value ratio or LTV, you may decide to save more money to put down a larger down payment and enjoy a lower interest rate. Additionally, you may choose to apply for a loan on a less expensive property so that you can own more equity in the home with the same down-payment amount, lowering your interest rate. Understanding your loan-to-value ratio can help you make decisive and strategic decisions.
Property and Occupancy Type
The property type is defined by the type of residence you’re purchasing. Your interest may vary based whether you’re purchasing a single-family home or an apartment. Multi-unit properties typically have higher rates, especially high-rise condos in highly populated areas due to the expectation of market volatility, and therefore higher perceived risk.
Occupancy type is whether you plan to reside in the property, use it as a second home, or rent it out, and can also affect rate. Rates for a primary residence are generally lower while second homes or rental properties carry higher risk, and therefore have elevated rates. Lenders assume your priority will reside in your primary residence and if anything were to happen, you may opt to stop paying your investment property mortgage before you let go of your primary residence.
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Depending on the level of your desired loan amount, your loan program, and rate will vary. Conforming loans, which have a loan amount threshold determined by the county in which you are purchasing, generally offer better rates as they are backed by the government which is perceived as potentially less risky.
Jumbo loans are a type of financing that exceeds the limits by county set by the Federal Housing Finance Agency (FHFA), are seen as riskier because of the high loan amount and therefore, may reflect a higher interest rate. It’s worth noting that jumbo loans carry their own complexities, so Neat recommends working with a jumbo loan expert to understand all the nuances of this loan type.
Debt to Income Ratio
This is a calculation of your monthly obligations divided by your gross income, providing a percentage that reflects your debt-to-income ratio. This ratio is used to estimate your ability to repay your loan. Obligations can include payments such as child support and other debts. If you have a low debt-to-income ratio, you may qualify for premium programs, which often carry low-interest rates.
Since it’s calculated looking into the future, obligations don’t include your current mortgage if you own a house that you’re selling, but it will include the new mortgage payment related to the new home being considered.
Reserves are the amount required to be set aside after the closing of a loan. This capital provides a buffer for you to continue making mortgage payments even if you were to temporarily lose your job or another income source. This added assurance helps your lender see you as lower risk. Higher reserves may qualify you for premium loan programs with lower rates.
This variable can significantly impact your home loan rate, especially if you plan to apply for a jumbo loan, which often carries more substantial reserve requirements.
Improving Your Rate
By knowing the factors that affect your rate, you can work to pay down debt, clean up your credit, and make improvements to your financial profile before applying for home financing.
If you’re ready to start looking, or are planning to start your home search within the next few months, make sure to your homework and talk to an expert early to avoid any surprises during your lending process.