|FICO Score||APR||Monthly Payment||Total Interest Paid|
As you can see, the lower a borrower’s credit score, the higher the APR, increasing both the monthly payment and the amount of interest paid over the life of the loan.
Before you apply for a mortgage, pull your own credit report (you get a freebie once a year by visiting annualcreditreport.com). Look for any errors or red flags, such as past-due accounts, late payments or accounts in collections. If you find errors, dispute them with the reporting creditor and the credit bureau. If you have a history of late payments, get back on track by paying those accounts on time every month – in full, whenever possible, or more than the minimum. Also, you’ll need to pull your credit scores from each of the three main credit reporting agencies: Equifax, Experian and Transunion. Check with your current bank or credit card company to see if they offer FICO scores for free, or you can purchase the scores directly from each of the three agencies for a nominal fee.
Knowing your scores now can help you better plan your home-buying budget and timeline. For instance, if your FICO score is below 620, you’ll have a harder time qualifying for many conventional loan products, though you will qualify for an FHA loan and other products. You might need to take a few months to work on your credit to raise your score so you can qualify for better interest rates and terms. Of course, interest rates can go up or down depending on market conditions so you’ll want to keep an eye on any big jumps in the meantime.
Understanding how your score is likely to affect your rate can keep you from accidentally signing up for a mortgage that is less advantageous than you deserve. Some subprime lenders (financing sources that provide high interest rate mortgages to borrowers with poor credit) market heavily to prospective homebuyers. Your knowledge of the market will protect you if you are approached by one of these lenders and have credit scores that should buy you better rates and terms than you’re offered.
Stable Income and Employment History
Lenders generally want to see two consecutive years of steady income and employment to ensure you can afford your mortgage payments and repay the loan over the long haul. If you’re a salaried employee, lenders ask for W2 forms and federal tax returns for the past two years to verify your income. Lenders also check with your employer to verify how long you’ve worked there. If your earnings have gone down or you’ve had gaps in employment in the last two years, lenders are skeptical of your ability to afford a mortgage and you might have trouble getting a mortgage preapproval.
Similarly, self-employed borrowers have to jump through more hoops to get a mortgage. If you are self-employed, expect to pay higher interest rates than what you see online; those rates are for borrowers who are considered more creditworthy because of their steady, verifiable incomes and excellent credit scores. Lenders also generally have stricter rules for verifying self-employment income. Not only will you need to provide federal tax returns for two years, you’ll also need to submit a signed statement from an accountant, a profit/loss sheet, and other documentation to show sufficient business income.
Lenders use your employment and income history to calculate your debt-to-income ratio, which plays a key part in determining your mortgage rate. If you can show proof of your income for a full-documentation loan, you’ll get more competitive rates and terms than other loan types for self-employed borrowers, such as a no-documentation loan or stated income/stated asset loan.
Lenders care about how much debt you have in relation to your gross monthly income. To calculate a borrower’s debt-to-income ratio, or DTI, lenders evaluate two formulas: a “front-end ratio” and the “back-end ratio.” The front-end ratio (also called the housing ratio) combines all monthly housing costs (mortgage payment, homeowner’s insurance, property taxes, HOA fees, etc.) then divides the sum by your gross monthly income. On the other hand, the back-end ratio (or total debt) combines all monthly installment and revolving debts (think credit cards, car loans and student loans), as well as the proposed mortgage payment, and divides the sum by your gross monthly income.
In evaluating these ratios, lenders presume that the higher your DTI ratio, the more likely you are to default on your loan. Generally, lenders want to see a front-end ratio no higher than 28% and a maximum back-end ratio of 36%. Some loan products allow borrowers to have a higher DTI ratio. FHA loans, for example, allow a back-end ratio as high as 43%.
Loan-to-Value Ratio and Down Payment
When you buy a home, you’re expected to make a down payment as an up-front equity payment on a home. While loan products have various down payment requirements, the higher your down payment, the lower your loan-to-value, or LTV, ratio. Lower LTV ratios (usually below 80% of the loan amount) earn you lower mortgage rates. Again, it goes back to minimizing the lender’s risk. If you have more up-front equity in your home because you’ve put down more money and have a lower LTV ratio, lenders are less worried about your risk of default. However, if you have little saved for a down payment and you’re financing most (or even all) of the loan amount, lenders stand to lose more money if you don’t repay your mortgage so they charge higher interest rates.
Low down payment programs help many buyers who haven’t saved a lot of cash, but these buyers generally pay higher interest rates than those who come to the closing table with a higher down payment.
Snagging the lowest rates and choosing the best mortgage for you involves doing your homework. Shop around with several types of lenders and look at various loan products to find the lowest rates and best terms. Also, pay attention to the lender’s fees and closing costs, which can add up at the closing table. While some of the pricing variances may not don’t seem big on paper, they can add up to significant cost savings over the lifetime of your loan. Keep in mind that some lenders will offer you discount “points,” a way to buy down your interest rate up front, which increases your closing costs. And other lenders that promote low or no closing costs tend to charge higher interest rates to make up the difference over the life of the loan.
In addition to checking with your current financial institution (a bank or credit union), ask a mortgage broker to shop rates on your behalf. Mortgage brokers aren’t lenders; they act as matchmakers between you and lenders in their network. They can save you time and money by comparing multiple lenders who have products that fit your needs. Also, it’s worth contacting some direct lenders, either online or in person, to see what they offer. There’s no magic number of lenders you should shop, but three to five loan estimates should give you a strong basis for comparison.
By applying for a mortgage with several lenders, you’ll receive loan estimates to compare rates and closing costs side by side. Also, if you do most of your rate shopping within 30 days, the multiple credit checks lenders perform will count as one hard inquiry and are unlikely to lower your credit score.
Locking in Your Rate
When you get an offer accepted, you have the option to lock in your interest rate with a lender. A rate lock is when a lender agrees to guarantee a specific interest rate at the time of the lock for a certain time period. This gives you time to finalize and close your home purchase and loan, and receive the same rate regardless whether rates move up or down in the interim. A rate lock protects you if interest rates rise before you get to closing; conversely, if interest rates decrease, you will not enjoy the benefit. Rate locks are generally valid for up to 60 days, but this timeframe can be longer or shorter depending on the lender.
It’s generally wiser to lock in a rate after you’ve signed a purchase agreement. If you don’t find a home right away, time is ticking on your rate lock agreement and it might expire before you make an offer. Then you’d have to pay for an extension, which can be costly. Speaking of costs, standard rate locks within 60 days are generally free, or a lender will charge a flat fee or percentage of the loan amount for this service. Rate locks generally cost about 0.25 to 0.50% of the loan amount (roughly a few hundred dollars). If you request a longer-term rate lock, expect to pay a higher fee.
Negotiating Your Rate
It’s possible to negotiate lower interest rates with lenders, but you need to comparison shop to do this successfully. Borrowers with strong credit, a stable income and employment history, and low LTV and DTI ratios generally have more negotiating power than other borrowers. If you have loan estimates from multiple lenders, you can try asking some lenders to lower rates or reduce some closing fees to win your business. There’s no guarantee you’ll be successful, but it doesn’t hurt to ask if you’re a well-qualified borrower.
Another strategy to get a lower rate is to buy it down through paying “points.” Points are essentially prepaid interest, and paying this cost up-front can help you save thousands over the loan’s lifetime if you plan to stay put. One point is equal to 1% of the amount being borrowed. For example, if your loan amount is $200,000, one discount point is $2,000 and two discount points are $4,000. Typically, paying one discount point can lower your mortgage rate by 0.25%, but this amount can vary by lender.
The Bottom Line
Finding the lowest mortgage rate involves research and shopping around. And it’s not the only consideration in finding the right home loan. Pay close attention to closing costs, which include a lender’s fees. Your loan estimate will outline all of these items line by line. To ensure you’re getting the best terms and rate possible, apply for a mortgage with a few lenders so you can compare offers side by side.
Comparison shopping will help you identify red flags, such as inflated lender fees or risky loan features, and help you narrow down your choices. Remember, a strong credit profile, low DTI and LTV ratios, and a stable income and employment history make you a more attractive borrower to mortgage lenders – and give you more bargaining power when it’s time to negotiate.