Seven Primary Factors that Affect Rate Calculations
You’re not the only one who’s asked us why you can’t get a rate like your neighbor! Find out how your unique situation impacts the seven primary factors that are used to calculate your interest rate. Since you cannot control market variability, learn what factors you CAN control when constructing your financial profile and choosing a loan with a competitive rate.
Your interest rate is determined by risk. Risk is calculated based on the likelihood of the lender receiving full compensation for the loan they have extended to you. 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 so that you can plan your loan structure accordingly.
Seven Primary Factors Affecting Rates
- Loan Transaction Type: Purchase or Refinance
- Credit Score
- Property and Occupancy Type
- Loan Size
- Debt to Income Ratio
1. Loan Transaction Type
If your neighbor is refinancing their home and you are buying your property, the transaction type – refinance or purchase – will affect your interest rate. Purchase transactions typically have lower interest rates because many loan officers run special incentives for home buyers.
If you’re refinancing your 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 types of refinancing options. With a cash-out refinance, for example, your rate would be offered at a premium. Thus, it is important to understand your options and construct your loan to reflect your specific objectives.
2. Credit Score
Your credit score is a number that represents your creditworthiness, and will directly impact your rate, particularly if your credit score is under 740 (Experian expects scores of 740 and above to receive better than average rates from lenders). Credit scores range from 300-850 and are determined by credit recording agencies. These agencies use proprietary algorithms to determine your score based on a multitude of factors.
Without a credit score, you will not qualify for a loan. 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, your credit score is considered to be excellent. Naturally, a high credit score correlates to a better interest rate and enables you to qualify for premium loan programs. This occurs because your perceived risk is rather minimal. As you can see, a clean credit score is imperative for qualification purposes.
A loan-to-value ratio (LTV) is the dollar amount of your loan divided by value of the property. This ratio therefore 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. Therefore, 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, your interest rate will decrease. This, in turn, would generally reduce the interest rate as the feasibility to sell your home if you were to foreclose, decreases because you own a good amount of the home and the lender has less invested in your home than you do.
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.
To see how your down payment affects your rate, check out our Home Loan Affordability Calculator and notice that when your down payment is less than 20% of the purchase price, lenders additionally require mortgage insurance, resulting in an additional monthly cost or an increase in interest rate to balance out the increased risk of approving your loan. Isn’t it nice to have the power to decide which structure better fits your needs up front?
4. Property and Occupancy Type
The property type is defined by the type of residence your loan would finance while occupancy type is defined by whether you will reside in the property, use it as a second home, or rent it out. An interest rate may vary based on a property type category such as a single-family home, multiple family home, or condos as well as the occupancy type. Traditionally, rates for a primary residence are generally lower while second homes or rental properties carry higher risk and therefore have elevated rates. This is because 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. Additionally, the best rates are often given to single-family homes while multi-unit properties such as apartments or condos typically have higher rates, especially high-rise condos in highly populated areas due to market volatility.
5. Loan Size
Loan size is categorized by county, but generally fall into three levels: agency loans up to $453,100, high-value loans from $453,101 to $679,650, and jumbo loans above $679,650 and greater than the high balance limit for your county (see FHFA High Balance Loan Limits for the 2018 here).
Depending on the level of your desired loan amount, your loan program and rate will vary. Agency and high-value loans are generally better rates because they are backed by the government which is perceived as potentially less risky. Jumbo loans are seen as riskier because of the high loan amount and therefore, may reflect a higher interest rate.
6. 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 are often defined as child support expenses and any debts. Because this is calculated looking into the future, it does not include your current mortgage if you own a house that you’re selling and will include the new mortgage payment you’re projecting to take on as a new obligation at the close on your home.
If you have a low debt to income ratio, you may qualify for premium programs, which often carry low-interest rates. A lower debt to income ratio, achieved by a higher amount of income than debt, your interest rate will decrease significantly than if you did not clear those debts from your financial portfolio.
Based on the industry standard of calculating your debt to income ratio, we recommend eliminating as many debts as possible or increasing your yearly income before applying for a new home loan or refinance on your existing property.
Reserves are defined as the amount required, “in reserve,” 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 income source. This added assurance helps your lender see your candidacy as a lower risk deal. That’s why a higher amount in reserve may qualify you for premium loan programs and therefore, lower rates.
This variable can significantly impact your home loan rate, especially if you plan to secure a jumbo loan which often carries more substantial reserve requirements. Without enough funds in reserve, you may not apply for some loan programs and thus, may have limited low-interest options. By saving a good amount of capital aside after closing, you are setting yourself up for success in earning a lower interest rate. To learn more about reserves in greater detail, read Reserves: What are they and Why do they Matter?.
Get A Better Rate Than Your Neighbor
Understanding the ways these seven factors affect your rate is the difference between knowing your loan will close with the proposed rate and hoping it might. Knowing how transaction type: purchase or refinance, credit score, equity, property and occupancy type, loan size, debt to income ratio and reserves will affect your overall home loan interest rate, you may begin adjusting your financial profile now.
As you adjust these seven factors to work in your favor, you might just earn a lower calculated risk and therefore, a lower interest rate than that of your neighbor (note: if one of these seven variables are different from your neighbor’s, you will get a different rate).
Due to the complexity of these seven primary factors, it is integral to account for them all upfront before moving beyond the pre-approval stage. Get the best rates and avoid rate surprises by partnering with a team focused on your best interest, guiding you through the home loan process using the most robust technology on the market. Ready to get started? Get a quick quote.