You may think that acquiring the lowest possible mortgage rate just requires shopping around for the best-advertised rate. While the mortgage rate is partly determined by market factors that you can't control, some factors under your control certainly will influence the interest rate you pay.
These factors fall into two categories – how risky it is for the bank to lend money to you, or how you can modify the loan to your advantage. Let's start by looking at your risk factors.
- Credit Score – This is probably the primary factor that affects your ability to get the lowest interest rate. The target varies by lender, but a credit rating near 720 or above usually earns a superior rate. Ratings in the 600's could result in as much as a 2% increase in your interest rate. Moreover, if your credit score is too low, you may not be offered a mortgage at all!
If you don't know your credit score, you should. You can check your credit score and read your credit report for free within minutes using MoneyTips Credit Manager. Resolve any errors as quickly as possible.
- Debt-to-Income Ratio (DTI) – This is the sum of all your debt commitments compared to your income. If you have other large debts or shaky income, banks will look at you as a higher risk for repayment, and rightly so. Most lenders look at 36% as the ratio where loans begin to get risky, but federally backed programs such as FHA loans or VA loans can tolerate DTI ratios in the 41-43% range.
If your DTI is lacking, you may need to consider buying a smaller house, or wait until other running debts are cleared.
- Stable Job History – A stable job history gives the banks greater confidence that your income stream will continue.
Healing these factors takes time. Meanwhile, interest rates are rising, but they are still low in historical perspective. Will the interest rate rise enough that your gains in risk factors are negated? That is something that you will have to determine for yourself.
If you decide to proceed, consider the second category of mortgage rate factors: modified loan terms. Here are some of the variables:
- Type of Loan – Instead of a fixed-rate loan, consider an adjustable-rate mortgage (ARM) or a hybrid loan with a fixed period followed by a variable rate. Initial rates are low, but your risks for high future payments are significant.
- Term of Loan – The length of the loan affects the rate, with a shorter term yielding a lower rate. For example, at the end of April 2016, interest rates were 3.83% for a 30-year fixed loan, 3.05% for a 15-year fixed, and 3.21% for a 5/1 hybrid ARM (5 year fixed period with yearly rate changes afterward).
What are the tradeoffs? With a shorter term, you have lower interest rates, but higher monthly payments. With an ARM or hybrid you pay lower interest rates and lower monthly payments in the short term, but will pay more in total interest over the long-term (if you don't refinance before the term is up).
- Paying Points – Points are effectively a prepaid interest charge, expressed as percentage points of the loan amount. Generally, a point (1%) lowers the interest rate by ¼%. These only pay off if you don't refinance or sell before the break-even point (savings on interest passes the initial cost of the points).
- Down Payment – A larger down payment constitutes lower risk, unless you are draining all your resources to make it. In that case, maybe you are buying more home than you can afford.
- Loan Size – Loans that are too small or too large tend to have higher rates. For small loans, less than $50,000-$100,000, lenders don't make much money without higher rates. Large "jumbo" loans (generally over $417,000) carry higher risks, and therefore higher rates. By making a larger down payment, it is possible to lower your interest rate if the smaller mortgage is no longer in the "jumbo" loan category.
In general, you can get the best mortgage rates by keeping a clean credit rating, controlling your debt, finding the best style of mortgage terms that fits your financial situation, and buying the size of house that you can truly afford. Nevertheless, don't forget to shop around! A great place to start is the online FHA Rate Guide, where you can get mortgage and refi quotes from multiple lenders, without leaving home!