Because your interest rate is the cost you pay to borrow money, it makes sense that you’ll want to strive to get the lowest rate possible. Even a slight difference can significantly affect the amount you’ll pay over the life of a loan.
Most people probably equate a “good” rate with the lowest average current rate. Certainly not everyone will qualify for the lowest rates they see out there, and the mortgage type—conventional, government insured, adjustable, fixed—and term will affect the rate, as will the state of the economy.
By comparing shopping and understanding the factors that affect rates, you can better navigate the mortgage market and find the best loan for your particular situation.
What Causes Rates to Fluctuate?
Interest rates are always changing. A variety of factors determine mortgage rate changes. Some you have control over, and others you do not.
One of the critical factors outside your control is what’s happening in the economy. Major economic events have a significant effect on interest rate fluctuations.
Inflation, which limits consumers’ purchasing power, also plays a role.
And the central bank of the United States, the Federal Reserve, may influence mortgage rate changes.
Interest Rates in Two Crises
Here’s a look at interest rate fluctuations in two turbulent eras.
In the early 2000s, lenders began offering risky mortgage options, known as subprime mortgages, to borrowers with poor credit.
An overheated housing market combined with subprime loan programs helped lead to the Great Recession, from December 2007 to June 2009, despite the Federal Reserve having drastically cut interest rates from 5.25% in September 2007 to 2% in April 2008.
For the next decade, the Fed kept interest rates very low to encourage borrowing and reinvigorate the economy. In 2018, it started to steadily increase short-term rates. Then came three rate cuts in 2019.
In March 2020, citing disruption caused by the coronavirus outbreak, the Fed cut the federal funds rate—the benchmark for most interest rates—to nearly zero.
And in January 2021, the Fed maintained its target for the federal funds rate at a range of 0% to 0.25%.
The Fed’s rate decisions usually drive shorter-term products like home equity lines of credit and credit cards.
Still, mortgage rates and the federal funds rate usually move in the same direction.
How Lenders Determine Your Mortgage Rate
In addition to economic and political factors and the influence of the Fed, your unique financial situation will help determine the mortgage rate you qualify for.
Here are a few key factors lenders will consider when determining your rate.
Most lenders review your credit history to determine if you’re eligible for a mortgage.
With this in mind, you want to make sure you check your score regularly and that you’re doing everything you can to keep your score as high as possible, like paying your bills on time and keeping your credit balances low.
Credit report agencies will assign you a credit score by evaluating these factors. The most common model is the FICO® credit score, which ranges from 300 to 850.
Usually if you have a credit score of 800 or higher, it’s considered exceptional, whereas a credit score between 740 and 799 is considered very good.
A credit score of 669 or lower ranges from fair to very poor. A low credit score demonstrates that a borrower is high risk. Lenders may deny the application.
It’s important to note that credit score requirements may depend on the loan you apply for.
Income and Assets
Your income is another important factor when lenders determine if you’re eligible for a mortgage. Lenders prefer borrowers with a steady income. To determine if you qualify, lenders evaluate your income and other assets, such as investments.
Also, your debt-to-income ratio is essential to lenders. Your DTI indicates what percentage of your monthly income is used for debt payments. This number gives lenders an idea of how well you’re doing financially.
If your ratio is high, it may show that you’re not in a position to take on more debt. A lender may give you a higher interest rate or deny your mortgage application altogether.
Down Payment Amount
Sometimes your down payment amount can lower your interest rate or determine what loans you’re eligible for. Lenders may see you as less of a risk since you put more money down.
A good standard is to save a 20% down payment. A 20% down payment may help you get the most favorable interest rates.
However, if you’re applying for a government-backed loan, you may not need as much. For example, a Veterans Affairs mortgage requires nothing down, and a Federal Housing Administration (FHA) loan only requires 3.5% down.
And some conventional home loans do not require 20% down.
Loan Term and Type
The loan term you select, such as 15 or 30 years, can also make a difference in the interest rate you receive. In general, a shorter-term loan will have a lower interest rate than a longer-term loan.
Then there are several loan categories, including conventional, FHA, USDA, and VA loans. Each loan product may have very different rates.
If you choose a fixed-rate mortgage, your interest rate will remain the same for the life of the loan. This means that even if interest rates fluctuate, your rate will stay constant.
If you choose an adjustable-rate mortgage, your interest rate will vary after an initial fixed rate for a period of time, such as five to seven years.
Therefore, before you take out any loan, it’s important to compare all of your options to make sure you identify the best rate available.
The location of your property can also play a role in the interest rate you receive. Some real estate markets are more costly than others.
Look at APR, Not Just Rate
Usually lenders express the interest rate as an annual percentage. An APR gives borrowers a more comprehensive measure of the cost to borrow money than the interest rate alone does.
The APR includes the interest rate, any points, mortgage broker fees, and other charges you pay to borrow money. So when you’re comparing options, you’ll want to review each lender’s APR to indicate the true cost of borrowing.
The Consumer Financial Protection Bureau, a government agency, offers a tool to look at state-by-state rates a borrower with a particular credit score might expect to receive.
To get an idea of what your mortgage payments may be, you can use a mortgage calculator.
Before Taking the Plunge …
With the historically low mortgage rates of late, it’s no wonder many buyers want to take advantage of this opportunity. But before you do, assess your financial situation, which will affect your rate as well.
Before taking the plunge, understand your budget and home affordability.
Some suggestions include:
• Pay off higher-interest debt. First, if you have debt, you’re likely paying a lot of money in interest. This money could be going toward other things like a mortgage payment once you pay off your debt. Second, carrying a large amount of debt means you lower your chances of approval for a home loan.
• Save more for a large down payment. Buyers who put down less than 20% may end up paying private mortgage insurance, which typically costs between 0.5% and 1.5% of the loan amount annually.
• Review your credit history and check for errors. The government offers a free annual credit report , which will help you review your credit history. However, it doesn’t show your credit score. If you spot any errors, be sure to address them to enhance your ability to get a home loan.
Making sure your finances are in order before you apply for a mortgage will likely help you obtain a better interest rate and loan terms.
What is a good interest rate on a mortgage? A tiny one, you might answer. But your financial health, the health of the economy, the loan type and term, and other factors will determine the actual rates you’re offered.
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