Your mortgage interest rate determines how much interest is added to your principal. Over time, even small variations in your interest rate can affect how much you pay monthly and the lifetime amount you pay before your mortgage is paid off. The U.S. Federal Market Committee establishes the Prime Rate, which affects mortgage interest rates; however, your individual financial situation is a significant factor in determining your interest rate.
Your credit score is a measure of your ability and willingness to pay your debts on time. This score not only determines whether you can qualify for a mortgage, but also helps banks establish your interest rate. Because borrowers with poor credit are riskier investments for the bank, their interest rates are higher. Factors that affect your credit score include whether you've paid your bills on time, how much debt you have, how many accounts you have, whether you've recently attempted to open new accounts and the types of accounts you have.
No matter how good your credit is, if you have more debt than you can pay, you're a big risk to the bank. Most mortgage lenders require at least two years of tax returns to verify your income, and then assign you a debt-to-income ratio that measures how much debt you have relative to your income. If your debt is too high, your interest will be higher and you may not qualify for a mortgage at all.
Your down payment helps pay off some of your mortgage before you even begin moving into your house. A larger down payment typically results in a lower interest rate. Your down payment also makes it less likely that you'll end up underwater on your mortgage because it immediately reduces the amount you owe on your house. Lenders are hesitant to lend to people who may be unable to make payments or whose home values might plummet, so consider making a large down payment if you can afford to do so.
The size of your loan can be a factor in your interest rate. Jumbo home loans, for example, typically have higher interest rates. Your prior history with mortgage payments is also a contributing factor. If you've defaulted on a home loan or experienced a foreclosure, you may be given a much higher interest rate. Borrowers who have had previous mortgages that they timely paid, however, typically get lower interest rates.
- Board of Governors of the Federal Reserve System: What is the Prime Rate, and Does the Federal Reserve Set the Prime Rate?
- Bankrate.com: How Credit Scores Affect Mortgage Rates
- Forbes: What You Need to Know About Mortgage Rates
- MyFICO: How My FICO Score is Calculated
- FHA.com: FHA Requirements: Debt Ratios
Van Thompson is an attorney and writer. A former martial arts instructor, he holds bachelor's degrees in music and computer science from Westchester University, and a juris doctor from Georgia State University. He is the recipient of numerous writing awards, including a 2009 CALI Legal Writing Award.