If you’re in the market to purchase a home, you know that mortgage rates are rising. Rates surpassed 7% for the first time in 20 years. And higher mortgage rates send monthly payments up significantly.
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A $240,000 mortgage at a 7.544% rate on a 30-year loan generates a monthly principal and interest payment of $1,658. At 3.00%, a rate available not that long ago, the payment was just $1,012. And this raises an important question—how do you get the lowest mortgage rate possible?
Several factors affect mortgage rates, including credit score, loan type and down payment. Here’s a list of five significant factors affecting your mortgage rate, plus actionable tips on how to get the best rate possible.
1. Credit Score
This one is no surprise. Lenders use your FICO score to determine how likely you are to repay a loan. A higher credit score usually results in a better interest rate, all other things being equal. Thus, it’s important to know your credit score and, if necessary, improve it before applying for a mortgage.
A good FICO score ranges from 670 to 739. Ideally, you want a score higher than that. According to myFICO, the best mortgage rates go to borrowers with a credit score of 760 or higher. Even if you don’t have an excellent credit score, however raising your score even a little can make a big difference.
Raising your score to this level can take some work. Two key factors are payment history and credit utilization. You want to pay your bills on time and keep your credit utilization as low as possible, with 30% as the upper limit.
2. Loan Type
There are various types of mortgage loans, from fixed-rate to adjustable rate mortgages (ARM) to government-insured loans. Generally, the interest rate for a fixed-rate mortgage may be slightly higher than the rate on an ARM. It can still be the best option as it insulates homeowners from future rate hikes.
At the same time, an ARM can be attractive. According to Forbes Advisor, a 5/1 ARM has a current rate of 5.71%, well below a 30-year fixed rate mortgage. Keep in mind, however, that after five years, a 5/1 ARM’s rate adjusts every year.
Finally, government-insured loans can offer better deals if you qualify. Two of the most popular are FHA and VA loans. VA mortgages can be particularly attractive, although the rates are still significantly higher than they were at the start of the year. With FHA mortgages, the rate can look attractive, but the fees associated with the mortgage can sting. As always, it’s important to shop around.
3. Debt-to-Income Ratio
Lenders look at your debt-to-income ratio (DTI), or the amount of your monthly debt payments compared to your income. To calculate your DTI, divide your total monthly minimum debt payments by your gross monthly income. Then multiply by 100 to get a percentage. For example, if you have a $1,500 mortgage, $400 car payment, and $200 student loan payment, your monthly debts total $2,100. If you earn $5,000 a month in gross income, your DTI is 42%.
Lenders use DTI as one factor in determining whether to approve the mortgage application. It can also affect the rate you can obtain. Fortunately, there are ways to lower your DTI.
Of course, one option is to pay off debts. This might be feasible if you have debts nearing the end of their term with small balances. Another option is to refinance debts to lower interest rates, longer terms, or both. The key is to lower your monthly minimum payments through the refinancing. Keep in mind that lowering your rate may not reduce your required payments if the term of the new loan is significantly shorter. This is something to be mindful of when using 0% credit cards to transfer high interest balances.
4. Down Payment
The size of the down payment relative to the value of the home affects the monthly payment in at least three ways. First, a down payment of 20% or more eliminates the need for private mortgage insurance (PMI). While the cost of PMI varies, it can add 1% to 2% of the mortgage amount per year.
Second, generally speaking, the higher the down payment, the lower the interest rate. Lenders use risk-based pricing, and the higher the down payment, the lower the risk, all other things being equal. An LTV of 80% or lower is generally good, as noted above regarding PMI.
Finally, the larger the down payment, the lower the mortgage balance. And a lower mortgage balance reduces the monthly payment and the interest you’ll pay over the life of the loan.
5. Loan Term
Your loan term, or how long you have to pay back your mortgage, also affects the rate. The two most popular terms are 15-year and 30-year mortgages. The 15-year mortgage generally comes with a lower interest rate. Keep in mind that the spread between 15-year and 30-year mortgages change daily. As of today, the spread is about 70 basis points, according to Forbes Advisor.
But don’t sign on just yet. A shorter loan term also means a higher monthly payment. That’s true even with a lower interest rate due to the significantly shorter term. I’ve always opted for a 30-year mortgage for the lower monthly payment. You can always choose to make extra payments on the mortgage at some point in the future.
Summary
Rising mortgage rates have reduced the size of a mortgage for which many can qualify. While we may long for the rates available just six months ago, there are steps we can take to get the lowest rate possible. It may take some effort and time, but lowering your rate by even 50 basis points can save thousands of dollars over the life of the loan.
