Let’s take a look at how each of these factors can affect the rate you get as part of a mortgage approval. After that, we’ll go over some strategies that can help you qualify for a low rate whether you’re looking to buy a single home or heavily invest in real estate. Before that, let’s take a moment and get back to basics.
What Is A Mortgage?
A mortgage is a type of loan that uses your home as collateral. It’s typically used to buy a home or in refinance situations to secure a more favorable deal and possibly convert equity in your home to cash.
If you have the resources, you could consider paying with cash, but most people either don’t have that option, don’t want to deplete their life savings, or divert money from other investments. Plus, mortgage interest is usually deductible on your taxes.
You usually have one mortgage tied to your home at any given time. However, one of the ways to access home equity is to take out another mortgage that takes second priority. You can also do a refi to fold your second mortgage back into a primary mortgage. We’ll touch on why you might do that a bit later.
Interest Rates Vs. APR
The first thing you need to know about mortgage rates, or any interest rates, is that you’ll often see two of them when you’re shopping around. The lower of the two interest rates is what your principal and interest payment is based upon every month.
The second, higher interest rate often displayed next to or below the interest rate for monthly payments is called the annual percentage rate (APR). The APR incorporates the interest rate associated with your monthly payment, but it also factors in closing costs and any applicable mortgage insurance payments. You can find all closing fees on your loan estimate.
APR is intended to give you a look at the true cost of the loan. One easy way to get an idea of relative differences in costs between lenders is to look at the difference between the interest rate and the APR. A bigger difference will mean more costs associated with originating the loan.
One strategy to keep closing costs down would be to have your mortgage broker or loan officer run through several scenarios so that you have some choices.
Calculating Mortgage Rates
If it’s your first time really dealing with mortgages, it can be tempting to think that a lender is setting their price arbitrarily based on a profit margin. While lenders do have flexibility to control their rates to an extent, the need to compete keeps rates from being too out of whack from one lender to the next.
To understand how mortgage rates are set, it helps to know a little bit about the mortgage market. Let’s briefly touch on this.
When you get a home loan, you might continue making payments on it for up to 30 years. Some mortgage lenders, like a bank or credit union, still practice portfolio lending, where they make money every month when you make a payment.
The problem with that is that lenders who follow this strategy need a ton of existing capital or wait several years to make money back before making loans to others. This isn’t good for those looking to finance homes. Most lenders follow a different strategy now.
The majority of lenders who originate mortgages now work with one of several major mortgage backers. The biggest mortgage investors are the government-sponsored entities (GSEs) Fannie Mae and Freddie Mac as well as the government agencies FHA, VA and USDA.
For the mortgages to be purchased by these entities, the loans have to meet their requirements, which include things like credit score, debt-to-income ratio (DTI) and down payment or amount of existing equity.
Once they’re purchased, the investors make them available on the bond market as mortgage-backed securities (MBS). These are collections of mortgage loans with similar characteristics in terms of risk.
As an example, an MBS might be based on 30-year fixed loans from Freddie Mac that have credit scores of 720 or higher and down payments of 20% or more. A single security might consist of 1,000 or more loans.
There are two forces that really drive what your mortgage rate is. One of these you have control over, and the other is all about economic chance and timing.
The prices of MBS, in part, are based on risk profiles. If someone believes you’re more likely to make your payment, they’ll be willing to accept a lower yield in exchange for certainty. If you have negative marks on your credit or a lower down payment, that’s slightly riskier and investors tend to want a higher return.
The Federal Reserve also occasionally jumps into this market and buys MBS in order to foster an environment of low rates.
The other part of mortgage pricing is somewhat out of your hands. MBS are generally considered a safe investment because you’re going to do your absolute best to make your mortgage payment every month. However, like most safe investments, the rate of return tends to be lower.
If people are feeling optimistic about the economic future of the country and the world, they tend to put more money in the stock market, which is riskier, but also offers a greater potential reward. If people are feeling more pessimistic, they turn to safer assets in the bond market, including MBS.
Yields run inversely with demand in the MBS market. The higher the demand for MBS, the lower the yield needs to be to attract investors. Lower yields mean lower mortgage rates.
Types Of Mortgages
There are several factors that distinguish each type of mortgage from the next. The most obvious distinction may be the type of interest rate you have, but there are also differences based on which mortgage investor holds your loan. Over the following sections, we’ll take you through what you need to think about to find the best mortgage for you.
Type Of Interest Rate
From a financial perspective, one of the single most important things you should be aware of is whether you have a fixed- or adjustable rate mortgage (ARM). Let’s run through the difference.
A fixed-rate mortgage is one in which the amount of your monthly payment that goes toward principal and interest stays the same for as long as you have the loan. Although over time, you’ll eventually pay more to toward principal than interest, the actual amount of the payment never changes.
It’s important to note that this isn’t to say that your mortgage payment can never change. If you have an escrow account for the payment of property taxes, homeowners and mortgage insurance, your payment may go up or down as these costs adjust each year.
The advantage of a fixed-rate mortgage is certainty. Your payment is going to stay fairly consistent. There are also a variety of options for your payoff term.
Mortgages with an adjustable rate work a bit differently. They typically (though not always) start with a lower rate. Given that they can adjust, investors don’t have to try to project inflation out so far. This is called the teaser rate.
Teaser rates remain fixed for the first several years of the loan – typically a period of 5, 7 or 10 years. After that, the rate can adjust up or down. If it goes up, the rate can’t rise indefinitely. The increases are subject to caps. Let’s run through an example.
Let’s say a lender is advertising a 5/1 ARM with 2/2/5 caps.
The 5 is the number of years the teaser rate is fixed. The 1 is how often the rate adjusts at the end of the teaser period – in this case once per year. The first 2 is the initial cap. The rate can only go up 2% on the initial adjustment, and the second 2 means the rate will only go up as much as 2% with each subsequent adjustment. The 5 at the end means that the rate can’t go up more than 5% for as long as you have the loan.
Anytime the rate adjusts, your ARM is re-amortized so that your principal and interest payment changes in order to make sure you pay off the loan at the end of the term. ARMs are typically a 30-year mortgage.
Adjustments are tied to an index level, which is added to a margin that the lender or mortgage investor sets. Government ARMs are often tied to the 1-year Constant Maturity Treasury. Meanwhile, conventional ARMs have often been tied to the 1-year LIBOR. At this time, Quicken Loans® isn’t offering conventional ARMs.
Because LIBOR has been subject to increased scrutiny after rigging in recent years, it’s being phased out by the end of 2021. The presumptive replacement in the U.S. is the Secure Overnight Financing Rate.
ARMs may temporarily give you a lower rate, but they also come with a higher level of risk, so it’s best to use them only if you know you plan to move by the time the rate adjusts or you’re comfortable with the possible fluctuation.
Conventional mortgages, also called conforming mortgages, usually refer to anything backed by Fannie Mae or Freddie Mac, although the term can apply to mortgages that others have invested in as well. We’ll focus on Fannie Mae and Freddie Mac here.
There are several requirements for a standard conventional loan from Fannie Mae and Freddie Mac. Among these are the following:
- The starting point to qualify for any conventional loan is a 620-median credit score from FICO®. Investment properties and second homes may require a higher credit scores depending on the type of loan you’re trying to get.
- Your debt-to-income ratio (DTI) should be no higher than 50%. DTI is a comparison of your monthly installment and revolving debt payments to your monthly gross income.
- For a primary residence, your down payment can be as low as 3% if you’re a first-time home buyer or fall into a low-to-moderate income category. A conventional down payment for a single-family residence wouldn’t be higher than 5%.
- Down payment requirements are higher for multifamily properties, vacation homes and investment properties.
- If you make a down payment of less than 20%, you will pay for private mortgage insurance (PMI), but you can request that it comes off once you reach 20% equity.
Anything not backed by Fannie Mae or Freddie Mac in the mortgage space is said to be a non-conforming loan. However, just because it’s given this distinction doesn’t mean you can’t get good deals on financing.
The most common types of nonconforming loans are those that come from government agencies themselves. Let’s run through some of these.
Because your primary mortgage is paid first, the second mortgage is usually given with a slightly higher rate to compensate for the additional lending risk.
Backed by the Federal Housing Administration, FHA mortgages have a number of advantages beginning with a minimum down payment of just 3.5%. Additionally, there’s some credit flexibility that’s not present in some other loan programs.
- It’s possible to get along with a median FICO® Score of 580 or better. However, you have to parts no more than 38% of your monthly debt expenses toward a housing with a total DTI of no more than 45%.
- If you have a median FICO® Score of 620 or higher, you can often qualify with a slightly higher DTI than you could on many other loans, although each loan is individually evaluated based on a number of characteristics.
- FHA loans have both upfront and monthly mortgage insurance premiums (MIP). If you make a down payment of less than 10%, the monthly premiums last for the life of the loan. Otherwise, they stick around for 11 years.
It’s possible to get an FHA loan with a credit score as low as 500, but you need a 10% down payment. It’s also important to note that because scores below 580 are considered subprime, you’ll likely end up paying a higher rate.
The minimum median FICO® Score considered by Quicken Loans for FHA approval is 580.
Available to eligible active-duty servicemembers, reservists, National Guard personnel, veterans and qualified surviving spouses, VA loans offer the opportunity to get into a home with no down payment requirement.
In order to qualify for a VA loan, you have to be financing a primary residence and meet the following requirements:
- Meet minimum service time requirements and have a Certificate of Eligibility.
- Although the VA does not set a minimum median credit score, different lenders set their own policies. At Quicken Loans, we require a score of at least 620.
- Your DTI can be no higher than 60% for a fixed-rate loan and 50% for an ARM. This could mean more money for a purchase preapproval.
- Instead of mortgage insurance, VA loans have a one-time funding fee of anywhere between 0.5% – 3.6% depending on things like the loan type, down payment or amount of equity and service status among other things. There are certain exemptions to the funding fee.
USDA mortgages are intended for those living in rural areas and on the edge of suburbia. The real benefit of this program is the ability to get a mortgage without a down payment. In order to qualify, there are several things to keep in mind.
- You and every adult in your household can’t make more than 115% of the area median income for your household size. Payments for childcare can be removed from income and students only have a certain portion of income counted.
- You have to live in a qualifying area. Generally, you’re safe if you’re away from the major metro, but they have an eligibility map.
- The USDA doesn’t have a minimum credit score requirement, but lenders can set their own.
- There are upfront and monthly guarantee fee payments that function like mortgage insurance and last for the life of the loan. However, these are lower than FHA MIP.
- You can only get a 30-year fixed loan through the USDA.
At this time, Quicken Loans doesn’t offer USDA loans.
Other Types Of Nonconforming Mortgages
In addition to government mortgages, there are plenty of other nonconforming loans you can get. Many of them are intended to help clients who have blemished credit and may not be able to qualify for other programs. However, there’s one type of nonconforming mortgage that’s probably the most common.
Conforming loans backed by Fannie Mae and Freddie Mac have loan limits. The standard national limit is $548,250, although limits are set from county to county in high-cost areas up to a maximum of $822,375 for a 1-unit property.
Any amount over the limits necessitates a jumbo loan. Unlike conforming and government loans, there’s no standard set of requirements. Financial institutions set their own policies. Here are the current policies of Quicken Loans:
- We do jumbo loans up to $2 million.
- To do a purchase or rate/term refinance on a 1- or 2-unit property with a loan amount of up to $1 million, you need a down payment of 20%, a median FICO® Score of 700 and a DTI no higher than 43%.
- There may be more stringent credit and down payment requirements depending on the type of transaction and loan amount.
Due to the higher loan amount, you can expect more requests for documentation as well as a larger amount of reserves to make your mortgage payment for a number of months if you suffer a loss of income.
Factors Affecting Your Mortgage Rate
Now that you know about the different types of mortgages, let’s go over the factors that affect what you can get for an interest rate on your mortgage.
Primary Vs. Second Mortgages
One way to access equity is by taking out a second mortgage. However, because your first mortgage takes priority, in the event that you run into financial trouble, your primary mortgage will be paid off first.
Due to the increased risk associated with these loans, second mortgages have slightly higher rates than primary ones. In contrast, in a cash-out refinance you take out equity based on your primary mortgage and you can get a lower rate. In addition, you can roll your second mortgage into your refinanced primary mortgage.
What’s IPAC? It sounds like a knockoff iPad on a late-night infomercial – “Call right now and we’ll double the offer!” Don’t worry, you can put the credit cards away.
IPAC is a convenient acronym to remember the factors that go into your mortgage interest rate: income, property, assets and credit.
The type of interest rate you can get – whether it’s for a car, home buying or refinancing or any other type of loan – is dependent upon the level of risk the lender is taking on that loan.
You don’t have to be a personal finance wizard to guess the following: Higher incomes likely mean you’ll have more resources available. This doesn’t mean you have to be a millionaire to purchase a $250,000 house, but the lender wants to see that you can comfortably make your monthly payment. This is determined by looking at your DTI ratio.
We’ll get deeper into this in the credit section below, but for right now, know that higher incomes mean more money to pay off debts including your mortgage.
The property portion of IPAC comes down to the type of property you’re buying. A lot of this depends on whether it’s your primary home, a second home or an investment property.
Again, interest rates are all about risk. When you buy a house, you know what you can afford and plan to make the payments. If you fall on hard times, however, you’re likely to pay off certain things before others.
Interest rates are higher for second homes and investment properties, because if something were to go wrong, you’d likely make the payment on your primary property first.
Interest rates are also different based on whether it’s a single-family property or a multi-unit complex like condos.
Higher assets are another thing that can work in your favor in terms of a mortgage. Assets are things not related to your annual income that could be used to help pay off your mortgage. This could be proceeds from the sale of property, stocks, bonds, mutual funds, etc.
Obviously, the more assets you have, the greater your ability to repay and the lower your interest rate will be.
All lenders look at your credit score and history. In general, the higher your FICO® credit score, the lower your rate. You keep your credit score up by making timely payments for your house, car, credit card and so on.
Your credit report is also used to determine how much of your monthly income goes toward making debt payments. Let’s say you make $5,000 a month and you pay $1,250 of that toward your student loans, house and car payments. Your DTI is 25%. The lower this ratio is, the less risky you look for the lender. Your rate will be lower.
For more on this topic, check out this post on how you credit score affects your mortgage eligibility and loan application. In short though, those with the best credit often qualify for the best rate.
Getting A Lower Interest Rate
Now that we’ve gone over the factors that go into your mortgage rate, how do you go about securing a low one? There are a few strategies you can employ to get the lowest rate possible.
Shorten Your Loan Term
You can save a lot of money if you shorten your term from 30 years to a 15-year mortgage. Even if you shorten to a term like 27 years, you can get a lower interest rate in addition to paying off your mortgage sooner because investors don’t have to project inflation as far out.
Although your monthly payment will be higher, you could potentially save tens of thousands in interest over the life of the loan. Not only will your interest rate be lower, but you’re also benefiting from the fact that you pay more toward your mortgage balance faster than you would on a traditional 30-year loan.
Pay Off Debt
While you don’t want to close every account, it can be helpful to pay off certain debts. Taking this action will decrease your DTI and free up more money for you to spend on your monthly mortgage payment. Less debt can mean a lower rate.
Prepaid Interest Points
You can buy your rate down by prepaying interest at closing. This prepaid interest is called mortgage points, also called discount points. One point is equal to 1% of the loan amount (i.e. on a loan amount of $100,000, 1 point is $1,000). You can purchase points in increments down to 0.125 points. Many of the interest rates you see advertised have a certain number of points attached to them.
Prepaying this interest will get you a lower rate. The trade-off here is that you have to stay in the home long enough to reach a break-even point where you save money. If buying 2 points on a $250,000 mortgage (2 points equals $5,000) saved you $300 per month on your mortgage payment, you’d have to stay in the home 17 months to break even. If you plan on staying in the house for a while, though, it’s a good way to save money.
Higher Down Payment
A higher down payment at closing will get home buyers a lower rate. Putting down a significant portion of the purchase price lowers the relative risk for a lender. The lower your loan-to-value ratio (LTV), the more you’re considered a good investment. Obviously, the higher your down payment, the less a lender has to give you to afford the home.
The bottom line is, the better your financial profile, the better the rate you’ll get. When you receive a quote for a rate, it’s unique to your personal situation.
Now that you’re a mortgage rates guru, apply online with Rocket Mortgage® by Quicken Loans.
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