You see advertisements for those historically-low mortgage interest rates everywhere. So naturally, you figure it’s time to refinance or apply for a new mortgage. But once your application is accepted, you realize your interest rate is one – or even two – percentage points higher than the national average. What happened?
In a nutshell, the lender thought you were a risk. That’s because one way to look at your mortgage interest rate is that it’s a representation of how much of a risk a lender believes you to be: the higher the risk, the higher the cost of borrowing the money.
The natural next question is: What makes for a low-risk mortgage applicant? Well, we spoke to some experts to find out. So read on to see what it takes to qualify for those super-low mortgage interest rates.
When a lender is deciding whether or not to let you borrow tens or even hundreds of thousands of dollars, they kind of want to know that you’ll pay it back. And for lenders, your credit score is an indicator of how risky lending you money might be – and therefore, how high or low your interest rate should be.
So what’s in a credit score? Credit scores run from 300 to 850 – and the higher the better, according to myFICO. “You get better rates with a better credit score. The higher the score the better the rate,” says Jim Duffy, a mortgage banker with Cole Taylor Mortgage.
But just how high does your score need to be to get the lowest interest rate? He says that to get the best rates you’ll want a score of 740 or above.
“Anything below 740 and you’re going to be paying a little bit extra,” he says. And if you’re wondering what that “extra” can amount to, it really depends on how low the score is. It can be as much as half a percent for a 620 score, but as little as an eighth of a percent or less for a score of 700, Duffy says.
You’ve heard the saying, “the more you make the more you spend,” right? Well, that could be a problem for your interest rate if your spending is driving your debt-to-income ratio up. You’re not sure what that is, you say? You might want to become familiar with it, because it’s important to your potential lender.
Your debt-to-income ratio is basically the amount of your gross monthly income that goes toward paying debt, says Justin Pritchard, a financial planner who writes About.com’s banking and loans column. So, say you and your spouse make a gross income of $6,000 per month and your debt is a total of $1,800 per month. Your debt-to-income ratio is 30 percent ($1,800/$6,000=.3). Pritchard says that your debt-to-income ratio typically needs to be 40 percent or lower to qualify for a mortgage, and lower percentages could mean lower rates.
Why? “Because lenders want to see that it’s easy for you to pay off the loan,” Pritchard says. “They want to know that you can suffer a setback, or get a pay cut, or take on more debt and still make your payments, versus somebody who’s spending 50 percent of their monthly income just to pay off debt.”
And if you’re wondering what lenders consider as debt, a general rule is that it’s anything that ends up on your credit report, says Duffy. Common things include credit card, auto loan, and personal loan debt. Your future mortgage payments (should you qualify for the loan), will also get factored in, he adds.
Not surprisingly, lenders like stability. After all, they’re deciding whether or not you can consistently pay a mortgage back, month after month, for years on end. So if you’ve been stable and consistent when it comes to your career, lenders could reward you with a lower rate.
And Pritchard says that the longer you’ve stuck with a career, the better, because it suggests stability. But don’t fret if you’ve changed jobs a few times. As long as the positions are in the same industry and have been consecutive, you can still qualify for the best interest rates, says Chris L. Boulter, president of Val-Chris Investments, Inc., a California company specializing in residential and commercial loans.
So, how long is long enough to be working in the same industry? At least two years is a must, Pritchard says.
On the other hand, “If you’ve had a disruption [i.e., have been fired or unemployed for a month or more] in your career in the last two years, the likelihood of you being able to qualify for the most favorable rates is extremely low,” Boulter says.
If you think about equity from a lender’s point of view, here’s what you would see: the more equity the homeowner (you) has in their home, the less risk the lender assumes.
To see why, first let’s define equity. It is the market value of your home minus any remaining mortgage balance. So, if your home is valued at $500,000 and your remaining mortgage balance is $400,000, you have 20 percent equity in your home. This essentially means that you own 20 percent of your home, and the lender owns 80 percent.
So how does this translate to risk? Basically, if the home’s value declines by up to 20 percent, you would lose money if and when you sell. But if the value of the home plummets 21 percent or more, the lender could potentially lose money instead, since the lender owns the rest of your home after that 20 percent.
In other words, if your home value went down by 21 percent and you sold the house or defaulted on the loan, you would lose $100,000, but the lender would also lose $5,000 (1 percent of $500,000 equals $5,000). So, if you only have 10 percent equity, your mortgage lender is “closer” to losing money because the market only has to decline by half as much (10 percent) before they are at risk.
And here’s a newsflash: Lenders don’t like to lose money.
So you need to have, in most cases, a minimum of 20 percent equity in your property to get the best interest rate, Boulter says.
On a purchase, this means making a 20 percent down payment. On a refinance, this means having 20 percent equity and only taking out a mortgage for 80 percent of the market value of your home.