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Three factors that determine what your interest rate will be
If you’re purchasing a home and applying for a mortgage, you’ll learn that a variety of factors affect the interest rate that you’ll be offered. Banks and Credit Unions assume a certain amount of risk when they loan money, and so they look at factors such as your current financial health, payment history, and debt obligations before setting your rate. Let’s take a closer look at three key factors and what they mean for you…
1. Credit score
Your credit score is a three-digit number that generally carries the most weight when it comes to determining your individual creditworthiness. When a lender is extending credit, it is the best predictor of risk. Some of the major factors that influence your credit score are your payment history, amount of credit utilization, length of established credit, types of credit, and the number of any recent applications for credit. Negative activity, like a missed or late payment, will lower your score, while responsible activity, like timely repayment and low credit card account balances, will raise your score. The higher your score, the greater the lender’s confidence in your ability to make your mortgage payments.
2. Loan-to-value ratio
The loan-to-value (LTV) ratio is calculated as the amount of the loan divided by the appraised value of the property and is expressed as a percentage. The higher the percentage, the less equity you have in your new home, which lenders believe brings more risk to the equation. For example, if the appraised value of your home is $125k and you finance $100k, your LTV is 80% (100k/$125k=.80).
In the eyes of a lender, borrowers with a higher loan-to-value ratio are more likely to default on their mortgage, and if that happens, the lender runs the risk of having to sell the property for less than the outstanding mortgage balance. Lenders prefer a lower LTV so that if the home goes into foreclosure, they stand a better chance of recouping enough money to satisfy the remaining loan balance.
In general, anything less than an 80% loan-to-value ratio requires additional private mortgage insurance, which protects the lender in the event the borrower defaults on the loan.
Borrowers with an elevated debt-to-income ratio carry a higher risk of default when it comes to loan repayment. That’s because debt-to-income is an indicator of cash flow. It is the percentage of income that is already dedicated to paying the borrower’s fixed expenses, like monthly bills, insurance, taxes and other financial obligations. With limited cash, one extra expense can easily derail a mortgage payment. The preferred DTI can vary from lender to lender, but the general consensus is around 36%.
When you apply for a mortgage loan, the lender assumes some level of risk by extending credit to you. The interest rate they charge is the cost of borrowing money, but it also includes a premium, which is based on the amount of risk. If your credit rating isn’t stellar or your numbers are in the red, you’ll probably pay more to borrow money from your lender in the form of a higher interest rate.
If you’re thinking about purchasing a home, be sure to check your credit rating, calculate your current debt-to-income ratio and consider homes that keep your LTV at a reasonable percentage. By being aware of your current financial health and working to improve these numbers, you could save a considerable amount of money when you’re ready to apply for a mortgage.