How does a lender determine your interest rate?

As a loan officer "what is your rate" is almost always the first question that is posed to me by a prospective client. My answer is the same every time "that depends on your situation". This answer never seems to satisfy the new prospective client but it is really the only honest way to answer the question. There are thousands of advertisements out there showing very low interest rates in big bold type with a lot of fine print. The fine print is important because those super low rates are always connected to non-traditional mortgages such as ARM's and the borrower must be considered 'ideal' in all areas. So, at the risk of exposing industry 'secrets', here is how your interest rate is determined.



SELECTING A LOAN PROGRAM
The first step in determining an interest rate is to determine what type of loan program is best for you. When helping a client select a loan program there are a couple of questions I ask. First, if it is a purchase, how much money would you like to come up with for the down payment? There are programs that allow for little to no money down and others that may require up to 30% down. They all come with pro's and con's. The next question is, how long do you plan to keep this loan? If your plan is to stay in the home for no more than 4 years, I may suggest looking into a 5/1 ARM that is fixed for 5 years at a much lower rate than a 30 year fixed loan. If you will not be in the loan by the time it is ready to adjust you may be able to save a substantial amount of money each month. The last question is, how quickly do you want to pay off this loan? Of course the shorter the term the higher the payment will be but you are always going to be rewarded with a lower interest rate if you are willing to pay off your mortgage in 10 or 15 years rather than 30.

DETERMINE YOUR 'HITS' TO THE BASE INTEREST RATE
Once you have selected your program, the loan officer will have to determine whether or not there are any hits to the base interest rate. A hit is an additional fee that is added onto your loan in order to retain the base interest rate. They are listed as a percentage of the loan amount and if you do not want to pay for the hits directly to retain the interest rate the lender can increase the rate to absorb the hits. A hit to your rate can occur for many different reasons and most borrowers will have a couple of hits to the posted base interest rate. Here is a list of common hits:

• Loan To Value Ratio (LTV) - This refers to how much equity is in the home. If the property is worth $400,000 and your loan is for $300,000 then your LTV is 75%. The lower the LTV the less of a hit you will receive.
• FICO Score - If your FICO score is under 750 there is a good chance that there will be a hit to the interest rate.
• Loan Amount - If your loan amount is over the standard conforming loan limit it is considered to be Jumbo and you will receive a hit to the interest rate.
• Location - Some lenders will hit you based on the state that the property is located in, typically this is due to higher rates of default in a state, or more intensive lending laws in a particular state creating more work or liability for the lender.
• Property Use - A non-occupied investment property will always have a hit to the interest rate, usually it is substantial.
• Property type - The standard property is a single family home. Any other type of property such a condo, duplex or townhouse will most likely have a hit.

As you can see there are a lot of factors. That is why you may see, for example, an advertised rate of 3.75% but when everything is taken into consideration the interest rate you are quoted comes in closer to 4.25%. In that case the rate is raised to absorb all of the hits to the base interest rate.

SELECT YOUR CLOSING COSTS
The final step that is taken into consideration when determining your interest rate is the closing costs. As the borrower you actually have a choice as to how much money you choose to pay in closing costs. That may sound ridiculous, if it is your choice then why would anyone pay closing costs? The answer is that the interest rate and closing costs have a direct relationship. If you choose to pay discount points you can reduce your interest rate and your payment. If you do not want to pay any closing costs you will have a higher interest rate and payment. Here is an example below of two 30 year fixed loan options:

Option 1: $300,000 loan amount, no closing costs, 4.25% interest rate, $1,475 monthly payment
Option 2: $300,000 loan amount, $3,000 cost (1 point), 4.0% rate, $1,432 monthly payment



Believe it or not, there can be other factors that come into play when determining your interest rate but this is a general idea of what is taken into consideration. The most important thing for you, the borrower is to recognize your own plan and priorities. In the end the best loan is affordable and in line with your long term plans. That is why my answer to the rate question is always the same. It truly does depend on your situation because what is right for your neighbor is probably not right for you.