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QUESTION: What things have an affect on a mortgage interest rate quoted to a consumer?
ANSWER: WOW, there are many variables that the average person is not even aware of so I will try and touch on each one.
AMOUNT OF LOAN – The amount of your loan may affect your interest rates due to the conforming loan limits established by Fannie Mae and Freddie Mac at the beginning of each year. If the amount financed exceeds the conforming loan limits that have been established for the year, interest rates can increase. Right now in our area, the conforming loan limit is $417,000 so any loan above that amount would be considered a "jumbo loan" with an increase in the interest rate that the banks are offering.
LOAN SIZE - There are usually adjustments made to the interest rate based on if the loan is to small in size. It's not uncommon for banks to cause ta slight adjustment to the rate if the loan is under $100,000 for example. Others have tighter limits and can sometime adjust the rate if the loan amount is less than $75,000 or even $50,000. It really depends on each banks guidelines.
LOCK IN PERIOD – When your rate was quoted, was it locked or floating? Unless you made full application and have a ratified contract, it is more than likely floating which means the interest rate can go up or down. Also the longer you ask a bank to hold the interest rate the more costly the loan. In other words a 45 or 60 day lock will cost you more than a 30 day lock because the bank is assuming all the risk of holding that money aside for you while the market is still fluctuating and if a loan officer quotes a rate that is good for 15 days, but the closing is taking place in 30 days, you can be certain the rate will change. Length of time the rate is good for is an important variable.
LENGTH OF LOAN – a shorter loan, lets say a 15 year vs. 30 year loan will have a reduced interest rate. This can save you thousands of dollars in interest payments over the life of the loan, but it will also raise the cost of your monthly payments.
TYPE OF LOAN – An adjustable rate mortgage may give you a lower interest rate than a fixed interest mortgage, but of course your payments are subject to increase as soon as the interest rate changes. Other mortgage types such as Option or Negative Amortization also play an important factor in the rate and payment quoted as do Interest Only loans. As long as I mentioned Adjustable Rate Mortgages, the frequency of how often they adjust after the fixed period, meaning every month, every six months, or once a year also plays into the interest rate. A five year ARM at one bank that has a lower rate but adjusts every six months may not be the best deal for the borrower as it is a more risky loan than an ARM that adjusts annually.
WHERE YOU ARE TRYING TO BUY - Did you know…That mortgage interest rates vary in every state and market? Yep it’s true!
Mortgage rates can vary drastically by state and market depending on what the specific market conditions are. So when you see on the evening news that that national average of a 30 year mortgage rate is for example 4.5%, that is just an average of all 50 states and markets and you may or may not be able to get that rate depending on where they are trying to purchase their home.
Look at the graph below at how different the interest rates were in one given day in 10 different markets.
Also be aware that national averages are just that, but you really don't know what the closing cost were on all those loans that make up the national averages and if points and other fees were being paid by the borrower which can influence rates.
Since mortgage interest rates are a product of each individual borrowers particular risk factors and credit profile, national rates while interesting, really do not tell the complete picture of each borrower in the composit overview and are a bit misleading.
SIZE OF DOWN PAYMENT OR LTV – The size of your down payment can also affect interest rates. Large down payments, usually those that are greater than 20 percent, will get you the best available rates. Smaller down payments of 5 percent or less will bring higher rates as you are offering less equity as collateral. If you have money on-hand when you apply for your loan and would like to lower your interest rate, it is a good idea to put more money down. The concept is simple: The lower the loan to value, (LTV) meaning the more money upfront, the more lenders are willing to lower the interest rate they charge, because there is less risk involved for them. This subsequently reduces your monthly payments.
NO COST OR LOW COST LOANS – Loans where the lender pays the fees will also have an affect on the final rate a borrower receives. While those loans are marketed as “No Cost” or “Low Cost” there is no free lunch and the consumer is ultimately paying for it as recently reported by Consumers Reports. In fact, the Attorney General in the state of California has outlawed the banks from advertising these loans as “No Cost, as he feels it is misleading. A no cost loan may or may not be right for the consumer but ultimately that feature will have an affect on the final interest rate. Also, if the borrower keeps the loan for a while and does not refinance or sell the home, the increased cost is paid over many years of the loan, making it more expensive for the consumer.
CREDIT SCORE – Your credit score will also affect your interest rates because they determine your willingness to pay past debts and are a measure of the likelihood you will be a good credit risk to the bank
DEBT RATIOS – If your income surpasses the amount of debt you owe, you will receive lower rates. However, if your monthly income is insufficient to meet minimum debt obligations, you will receive a higher interest rate, even if you have a great credit score.
CONSTRUCTION TYPE – As a general rule, stick or site built have lower interest rates and lending guidelines than manufactured homes. Typically condos will have different lending standards and interest rates as do townhomes. The proportion of homeowners to renters in a condo and townhome project usually will affect the interest rate, and in some cases it may prevent financing at all. The term the lenders use for the percentage of owners vs. renters in a project is called warrantable vs. non-warrantable.
ORIGINATION AND POINTS – A point and origination fee is equal to 1% of the loan amount and these costs have an affect on the interest rate. On average, a point equates to roughly a ¼% interest rate reduction. When a borrower obtains a rate quote it is important to know just how much in points and origination fees there are. Of course all this assumes the loan officer is not low balling the rate quote just to get the borrowers loan.
PREPAYMENT PENALTY – If a borrower was confident that they would not be refinancing or moving for a certain period of time, say 1-3 years, a prepayment penalty potentially could be used to lower the interest rate. Not all banks offer pre-payment penalties but it is a viable topic to discuss when considering interest rates. The big problem is that many consumers, who had shopped around for a loan thinking they found the best deal, were not aware that the loan had a pre-payment penalty until the day of closing.
PURCHASE, 2ND HOME, INVESTMENT OR REFINANCE – Every type of loan has a slightly higher rate structure and qualifying guidelines. A primary residence has the best interest rates, a 2nd home slightly higher and an investment home has even higher interest rates and qualifying guidelines. When it comes to refinance transactions a simple rate and term refinance where there is no cash being taken out qualifies for the best interest rate, however take cash out, and that’s an entirely different story with higher rates being charged for the higher element of risk. By the way, when a borrower refinances and pays off their home equity line, it is considered a cash out refinance with the appropriate higher interest rate. While you may wonder why the bank considers this a cash out refinance, you need to consider that the borrower did cash out their equity with the use of a home equity which is now being refinanced into one loan.
As you see there are many variables that have an affect on the interest rate a borrower is quoted and qualified for. In short it all of these variables fall under something the banks call RISK BASED PRICING.
Risk-based pricing is a system that evaluates the risk factors of your mortgage application and credit profile and other variables and then adjusts the interest rate and discount points up or down based on this risk evaluation.
Rates posted on the internet and in bank branches are the absolute best case scenario, they have to be as no bank would post their highest rate but unfortunately it’s all the reasons listed above that make it very difficult to recognize a good loan.
Let me now give an example of how all the variables come together. Let's assume in this example that the base interest rate that the bank is offering the day you want to lock you loan is 4.750%. Let's also assume that you need to lock the loan for say, 45 days. Also, assume that the 4.750% rate the bank is offering is subject to you having a minimum credit score of 620 but your score is 610. Another asumption in this example is that your debt ratios are a little higher than what the bank would normally want to see. Let's use for this example a debt ratio of 38% is what the bank requires to get that 4.750% rate but your debt ratios are 41%. One last adjustment, assume that you are not putting 20% down but are financing 100% or close to it. The higher the loan to value the higher the rate charged by the bank.
Here is how all this would look with regards to the risk based pricing and the adjustments to the rate. (Remember this is just an example of how risk based pricing works and there are many more variables that potentially could affect the final interest rate a borrower receives. The adjustments in the example below are different from bank to bank.)
- 4.750% Base rate
- .250% For a 60 day interest rate lock
- .750% Adjustment for the credit score
- .375% Debt ratio adjustment
- .500% LTV adjustment for little money down.
- 6.625% Final rate to the borrower for the risk factors
As you can see, the adjustments to the base interest rate of 4.75% that the bank was advertising made the final interest rate much higher.
Here is another example:
I am not allowed to publish a banks rate sheet, but I did recreate a section of it below to use as an example. Be aware that there are many matrixes on a rate sheet and this is a good example of what one looks like.
The graph below, is an example of Loan to Value (LTV) and credit scores.
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Step 2: Find your loan – to – Value Range |
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< 60% |
60.01-70% |
70.01-75% |
75.01-80% |
80.01-85% |
85.01-90% |
90.01-95% |
> 95% |
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Step 1:
Find your credit score range |
> 740 |
-0.250 |
0.000 |
0.000 |
0.000 |
0.000 |
0.000 |
0.000 |
0.000 |
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720-739 |
-0.250 |
0.000 |
o.000 |
0.250 |
0.000 |
0.000 |
0.000 |
0.000 |
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700-719 |
-0.250 |
0.500 |
0.500 |
0.750 |
0.500 |
0.250 |
0.250 |
0.250 |
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680-699 |
0.000 |
0.500 |
0.500 |
1.000 |
0.250 |
0.500 |
0.500 |
0.500 |
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660-679 |
0.000 |
1.000 |
2.000 |
2.500 |
2.250 |
1.750 |
1.750 |
1.250 |
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640-659 |
0.500 |
1.250 |
2.500 |
3.000 |
2.750 |
2.250 |
2.250 |
1.750 |
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620-639 |
0.500 |
1.500 |
3.000 |
3.000 |
3.000 |
2.750 |
2.750 |
2.500 |
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< 620 |
0.500 |
1.500 |
3.000 |
3.000 |
3.000 |
3.000 |
3.000 |
3.000 |
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Step 3: Find the intersection for your pricing adjustment |
In the above example, let’s assume that a borrower has a credit score that falls between 640 and 659. Another assumption is that the down payment is 5 % or less, much like an FHA or Rural Housing loan. If you follow the table, the adjustments (in red) on the borrowers cost of the loan is a whopping 1.75% in points!
So to get lets say a banks best rate for the day that is advertised at say 5.125%, the borrower would need to pay 1.75% in points on the loan to get that rate and this increases the closing costs. On a $125.000 loan amount, this is an additional $2,187.50 in closing costs.
There is an alternative especially for those cash poor buyers. Most of the time, the fees can be converted into the interest rate. In the example above, the buyer would have an increase in the rate of roughly .750% making the final rate the customer would pay on the loan at 5.875%.
Be aware that this still does not take into account any other adjustments for items such as:
- The homes property type (owner occupied primary residence, 2nd home, or an investment property.)
- Construction type (manufactured, stick built, condo.)
- The reason for wanting the mortgage such as (purchase money, rate and term refinance, cash out refinance.)
- Loan Lock length of time (15 – 30 – 45 – 60 days etc.)
- High Debt Ratios
- Geographic location (yes rates vary state by state and this factor is even more prevalent in states with high fraud or foreclosures.)
- Amount of the loan (jumbo loans have higher pricing to start with.)
Risk based pricing, or as Fannie Mae calls it, Loan Level Pricing Adjustments has become the norm in today’s lending environment, and it is likely to stay around. Fannie’s risk-based fees were first introduced in April 2008 and there have been 4 revisions, each increasing the amount a borrower has to pay to obtain a mortgage.
Some people consider this to be unfair, but in reality what it is doing is allowing someone to continue to purchase the home they want by being able to obtain a loan vs. not getting a loan at all. In other words if there were no adjustments to the interest rate, the borrower in the above scenario would not have qualified at all because of credit scores, debt ratios etc.
If there was one interest rate for all borrowers, then those with less risk factors and better credit etc would be subsidizing those who were of higher risk which is not fair either.
Risk based pricing is also used in another industry that we are all familiar with, the auto insurance industry.
With auto insurance, the cost of a policy increases as a drivers risk to the insurance company increases. A "safe" driver gets rewarded with a lower premium and a driver who is considered a higher risk, either by their age or moving violations etc has a higher insurance cost.
To re-cap: You can see that there are many variables that go into calculating the interest rate a borrowe receives. Sometimes these are a part of the risk based pricing model the banks use and other times it's a loan officers who is not being truthful when quoting rates and fees.
Now that you know that there are many variables that can influence the interest rate, think about this.
If you are calling lenders trying to get an idea about where interest rates are and the Loan Officer is not asking you questions about the material contained in this article, then it's a safe bet the rate being quoted is worthless.
If you have questions about this or any other mortgage lending related topic, please contact me. It's my pleasure to help!
Mark A. Miskiel
"Delivering a level of service that can only be described as exceptional"
928-634-7987
miskiel@msn.com
NMLS # 198563
First time buyer loans, Purchase, Refinance, ARM Conversion, Combo Bill Pay, Construction, 2nd Home, Investment, 100% Financing, Lot Loans, Reduced/No-Closing Cost Options, Reverse Mortgages, FHA, VA, Rural Housing, Lot Loans, Manufactured.
 BK-0909441
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