How do lenders determine your mortgage rate?
Mortgage rates are tied to a variety of indexes such as the mortgage bond index, the LIBOR index, etc. These indexes change continually which is why mortgage rates are an ever moving target, though usually stay within a relatively small range on a daily basis.
Banks will add their profit margin to the index rate to determine their “best rates” at any given time. “Best rate” is the key here though. Depending on the type of mortgage you are applying for, your lender may make adjustments to that “best rate” based primarily on your credit score and amount of down payment.
Conventional financing (Fannie Mae loans)
After the recent housing crash when so many home owners who had adjustable rate mortgages lost their homes, most buyers who qualify are opting for 30 year fixed rate mortgages.
IF your credit score is at least 720 AND you have a 20% down payment, AND there are no recent prior derogatory credit issues (such as short sale, foreclosure, bankruptcy), AND you don’t need a co-signer, you should qualify for the best conventional rate you see quoted all over the Internet. But remember that those posted rates may be quoted just once a day, while rates can move up and down, even during the course of a single day.
Important note: Rates quoted on the Internet are often for adjustable rate loans or include a buy down cost.
The reality is that mortgage rates are all about risk. Currently mortgage rates are very low compared to historical averages. This is risky to lenders because you are locking in your rate for 30 years. Banks are all too aware that means that if you keep your house and take the full 30 years to pay it off, they will likely experience an interest rate loss on you at some point during that 30 years as mortgage rates rise. That’s why they build in a substantial profit margin over the rates they are paying to borrow money to lend to you.
If your credit score is below 720, or if you have less than 20% down payment, or if you can’t qualify based on just your own income; you are considered a higher risk, so you will be charged a higher rate to minimize that risk to the lender. We refer to this as “risk based adjustments”. Also, the type of property you are purchasing can trigger risk based adjustments. For example, you will pay a higher rate if purchasing an attached condo. You very likely will not be able to purchase a manufactured home even if you own the land under it, nor a floating home, even if you are also buying the slip, with conventional financing.
ARM (Adjustable rate mortgages)
Adjustable rate mortgages are still available. You’ll hear them referred to as 5/1 ARM, 10/1 ARM, etc. These loans have a locked in fixed rate for 5 or 10 years, or whatever type of ARM you have, but then the rate can (and usually does) begin to rise, as often as twice a year, and up to 2% at a time. For the lender, this means you are assuming some of the interest rate risk so ARMs are generally offered at lower initial rates than 30 year fixed rate loans. It is highly advised that unless you are absolutely sure that you will sell your home prior to the end of the locked in rate period, because the rates increases can be quite a shock to most home owners when they kick in, you should choose the 30 year fixed rate loan if you can afford to do so. (Your mortgage rate can go from 3.5% to 5.5% over night!)
Conventional ARMs are also subject to risk based pricing adjustments. So, all of the above mentioned variables can apply to these loans as well as 30 year fixed.
Conventional financing can end up being very costly for those who do not qualify for the best rates, because when it comes to risk the banks always win. Buyers always pay for higher risk.
Other loan options
There are several other types of mortgage financing available. FHA, VA, USDA, private lenders, hard money, etc. Each type of financing comes with its own good, bad and ugly features, so each type of financing should be looked at and carefully considered when you are shopping for home financing.
FHA has historically been the option for those who are credit challenged. But, increasingly, those with lesser down payments are opting for FHA financing because the minimum down payment is only 3.5% of the purchase price, and, the fact that you have only 3.5% to put down does not affect your rate. BUT, FHA covers their risk by charging you both an upfront fee for the loan, plus monthly mortgage insurance to cover their risk for the life of the loan. Rather than the rate, the amount of the monthly mortgage insurance will be affected by how much risk you are to the lender. For example, if your credit score is lower (as low as 620), or if you have prior derogatory credit issues, you will be charged a higher monthly mortgage insurance premium. Some lenders do offer FHA financing to borrowers with credit scores lower than 620, but then rate as well as mortgage insurance will be higher.
FHA rehab loans are a great option for those who want or need to purchase a lower priced home that requires renovations in order to make it safe and habitable. Make sure, if you are looking at fixers, that your lender is aware of this in advance, because there are defined steps you must take in order to close your purchase. Otherwise, FHA is very picky about the properties they finance and have very strict standards about the condition of the property if you are not getting a rehab loan.
Another downside to FHA financing is that the maximum purchase price is lower than the maximum price for conventional financing.
FHA does lend on manufactured homes, but does require a minimum 20% down payment, and these homes must be in excellent condition and must have been built after 1978.
USDA loans cover up to 100% financing! But there are restrictions.
They are offered only in “rural” areas (as determined by population as of the last census.) In the Portland metro area, USDA loans are pretty hard to get, because only neighborhoods that are way out from downtown Portland still qualify. Additionally, there are income limits for home buyers, maximums on purchase price, and minimum credit scores are higher than for FHA financing.
But, if you are looking in a USDA eligible neighborhood, be sure to talk to your lender about whether or not this option will work for you. Anyone who qualifies gets the best conventional 30 year fixed rates with zero down payment and minimal mortgage insurance premiums.
VA loans have been around forever, and what a great program they are for veterans. In most cases, there is zero down payment required, and vets will get the best rates with lower credit scores as well. They do have to pay mortgage insurance, but it is minimal as compared to the MI charged on FHA or conventional loans.
Thank you veterans for your service! You definitely deserve the best mortgages possible for the sacrifices you have made for the rest of us.
Hard money and private lender financing
As a general rule, only those who cannot qualify for any of the above types of financing will turn to hard money or private financing. The exception is when you want to purchase a property that does not qualify for any of the more well known forms of financing. If you seriously want to purchase a home and cannot get a loan, be prepared to pay much higher rates and more points for your loan. These private lenders know you have no other options, and are in a position to take advantage of that fact. Also, these lenders almost never lend without your having considerable “skin in the game” in order to protect their investments in you.
It’s important to talk openly with your realtor and lender when buying a home
Because a mortgage is the biggest debt most people will ever take on, and buying a home is the biggest and one of the most eventful purchases of your lifetime, home buyers need to talk openly with both realtors and lenders to help us guide you to the best purchase and financing for your unique circumstances.