How lenders calculate your mortgage interest rate
June 25, 2010
SOUTH LAKE TAHOE, Calif. – When I was starting out in the real estate lending industry, things were pretty simple. You either put down a 20 percent down payment or you used Federal Housing Administration or Veterans Affairs financing. There were only a couple of interest rates, based on how many points that you wanted to pay. There were no credit scores and your credit history either passed or failed and that was a judgment call.
Things were pretty simple then. These days? Not so much. The process of determining your interest rate is fairly complex but this matching of a specific interest rate to a particular financial profile opens the door to a larger number of buyers. Just like no two snowflakes are alike (and hopefully we won’t see any snowflakes for the next few months) almost everybody has a different set of factors that determines their home mortgage interest rate.
Really, this new “risk-based pricing” concept was overdue. With everyone’s financial profiles being so unique, and often so complicated, it really never made sense that one interest rate should apply to practically everyone, even though some borrowers were simply a much better credit risk than others. But like most things in life, this process has become so complicated that we often need to submit the borrower’s financial data through the lender’s automated pricing program to determine an interest rate.
So what factors determine the rate? In a lot of ways, it is almost common sense. How much equity you have in your home, or how large of a down payment if you are buying, matters a lot. It’s like a relationship: the more time and love you have invested the harder you’ll work to save the relationship. Similarly, the more money you have invested in a property, the harder you’ll work to save that investment. But just because you have lots of equity in your home, you’ll still have to jump through a few flaming hoops. And if you don’t have much equity, you’ll pay a surcharge, because this kind of loan is just riskier for the lender.
Another critical factor in determining your interest rate is your credit history. Every facet of your past credit is summarized in a three-digit number known as your FICO score. This score normally ranges from a low of around 500 to a high of about 800. A score more than 680 is good – you’ve consistently attended to your obligations and you appear to be a prudent user of credit. But lately, lenders have raised the bar, making 740 the new 680. And the three credit scoring models have been redesigned, resulting in generally lower scores for everyone. Fact is, only about 10 percent of the country has a score above 740. The lower your credit score, the greater that surcharge – again, this is how lenders mitigate increased risk.
If your score is “credit challenged” or you have a small down payment, you’ll be best served by looking into a government loan. The Federal Housing Administration has been around since 1934 but fell out of favor in the past decade due to their previously very low maximum loan amounts and because of fierce competition from sub-prime lenders. Well, the sub-prime lenders are gone and FHA loan limits are way up ($580,000 in El Dorado county and $468,750 in Douglas county), making FHA once again an excellent choice for the first-time buyer or for the person whose credit score has suffered. Unlike any conventional lender, FHA even allows refinances up to 97 percent of your home’s value.
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The dollar amount of your loan also impacts your interest rate. Lenders will charge a small premium for very small loan amounts, such as loans less than $75,000 and they’ll charge a premium for loan amounts between $417,000 and $580,000 in El Dorado county. The range between these two loan amounts is the “conforming jumbo” loan product and the maximum loan amount varies by county. These “Confumbo” loans are supported by Fannie Mae and Freddie Mac, just like most home loans, so the interest rate is much lower than for a true “Jumbo” loan. The jumbo loan market is slowly making a comeback as investors are presently putting a toe in the water.
Another feature that affects your rate is the interest rate “lock.” The rate lock is like an insurance policy that protects against your rate increasing during the loan process. You pay a premium – the longer the rate-lock period, the greater the cost – but that premium is money well spent if rates soar while your loan is in process.
There are surcharges for so many reasons. Is the property a duplex or triplex? Do you want an impound account so that your taxes and hazard insurance are included in your payment? In what state do you live? Is this your primary residence or a rental property? Is the property a condominium? Are you refinancing to take cash out? And interestingly, every lender has slightly different rules and surcharges.
Every element of your financial profile and your loan characteristics affect your ultimate interest rate. So, if your neighbor wonders why your rate is so much different than her rate, these are some of the reasons. And as with any major undertaking, I cannot overstate the importance of relying on a trusted, experienced mortgage professional. Be sure that your mortgage professional knows how to navigate the complex waters of the modern mortgage industry.
– Mark Treiber is a loan agent with RPM Mortgage. He can be reached at (775) 586-1130 or through http://www.rpm-mtg.com/mtreiber.