After deciding on the best type of mortgage loan for your financial situation and choosing a lender to service that loan, it is necessary to understand what factors will influence your monthly mortgage payment, and what you can do to ensure you reach the best payment structure for your new home.
Credit Score
The rate for a home mortgage or commercial real estate loan is based on the risk you present to the lender. One way mortgage lenders measure this risk is by evaluating the credit profile of the borrower. To analyze this, a local bank, credit union, or another mortgage lender, will pull your credit report and score to take a close look at your credit file which represents your creditworthiness.
These aspects of your financial life provide some insight into your previous borrowing behavior – both the good and the bad. Some of the major factors the lender will take into consideration are as follows:
1. Length of Credit History
Your credit score will show how long you have maintained each of your sources of credit. That can include a student loan, other mortgages, auto loans, credit cards, equity lines, and other types of short and long-term credit. As a general rule, the longer your credit history, the more favorable it looks to the lender.
2. Past Delinquencies
Most lenders tend to predict future behavior from what they can observe from the past, which in this circumstance is the number of late or delinquent payments on your credit report. The lender also considers when these delinquent payments occurred.
The more recent these appear, the worse for you as the borrower. Recent issues with paying your debts on time will severely affect your credit score and can negatively affect the interest rate and the repayment terms of the mortgage loan you are applying for.
3. Credit Usage
Once the lender knows the amount of credit you have at your disposal, they will then evaluate how much of that credit you are using. This is known as your credit utilization ratio. The closer you are to maxing out revolving credit lines (e.g., a credit card or home equity line of credit), the riskier you will appear to the lender.
4. Credit Mix
Your mixture of credit (revolving credit, installment loans, and a few less-popular types of credit) is also taken into account by the mortgage lender. If the mixture represents a blend of different credit account types, it is often viewed as less risky. It’s generally a good idea to have a variety of account types rather than just a bunch of credit cards, loans, or otherwise.
Evaluating Your Credit
Overall, the higher your credit score, the better your terms will be from the lender. Each borrower will fall into a particular range and that range will help the mortgage lender determine the risk of lending you money. The higher the range the less risky you appear, the lower the credit score range the risker your look to them.
Before applying, it is important to know for yourself what exactly is on your credit report, as there are sometimes errors that could end up costing you in terms of your interest rate, and in turn, a ton of cold hard cash over the long run.
Once you obtain your credit report, it is important to do a few things:
- Review the entire report for errors
- Check for items you don’t recognize
- Take note of delinquent or late payments
- Remedy outstanding balances
- Ensure the accounts shown are yours
- Dispute details that aren’t accurate
How Mortgage Interest Rates are Set
A second important point many borrowers should know is how the interest rates advertised by mortgage lenders are set. For the most part, the rates are not set by the individual lenders, but by the secondary markets – the institutions buying the mortgages made by these lenders.
Rates are primarily determined relative to the current risk-free rate. Typically, the 90-day US Treasury bill is used for this benchmark. From here, the banks add premiums to this rate to compensate for additional risks, as a mortgage loan is not ‘risk-free.” These additional risks include an inflation premium, a default risk, a liquidity premium, and a maturity premium.
So, adding all these risks to the current 90-day US Treasury rate, the bank gets a ballpark idea of the rate they will charge for each type of loan, e.g., conventional, FHA, VA, USDA, ARM, 15-year, 30-yr, etc.
Up Next, Key Items Included in Your Closing Costs
Check out our next article covering major items included in your closing costs, some that also affect your annual percentage rate (APR), such as the down payment, points, and mortgage insurance.
