How a borrower's mortgage interest rate is determined

Ever wonder how a lender decides the interest rate you qualify for when you apply for a home loan?

Mortgage rates are partially a function of overall market levels, which are significantly affected by decisions of the Federal Reserve. If market rates are in the 5 percent range, for example, then most borrowers won’t get rates of 3 percent or 8 percent.

Beyond that, however, lenders use certain factors to determine what an individual home loan applicant’s interest rate will be. These factors include:

Credit score. A credit score is a numerical representation of a borrower's credit history. The score measures whether the borrower uses credit responsibly and pays his or her bills on time. All other things being equal, lenders offer lower rates to borrowers who have higher credit scores and higher rates to borrowers who have lower scores.

Type of loan. Lenders charge different rates for different types of loans. For example, a borrower who applies for a jumbo loan to buy a house in a high-cost housing area typically is charged a slightly higher rate than a borrower who wants to buy an average-priced home in most parts of the U.S.

Fixed or variable. Lenders charge lower rates when the borrower chooses a loan with a variable rate instead of a fixed rate. That's because variable or adjustable-rate mortgages, known as ARMs, transfer some of the market rate risk from the lender to the borrower. If market rates rise, the lender can pass the cost of the higher rate along to the borrower. If market rates drop, the borrower gets the advantage of a lower rate. Whether up or down, ARMs are subject to certain limits and caps that protect the borrower from a large jump in his or her rate. Instead, the borrower's rate can rise more slowly over the loan's term.

Loan term. Borrowers who select a 15-year loan instead of the more common 30-year term generally will be offered a lower rate. That's because a shorter term is less risky for the lender. A loan with a shorter term will have a higher monthly payment than a loan for the same amount with a longer term, even if the interest rate is lower.

Owner occupancy. Borrowers who intend to occupy the home that secures their loan as their principal residence typically will pay a lower rate than borrowers who want to finance an investment property they intend to rent out to tenants. That’s because lenders believe rental property loans are at greater risk of default than loans for property in which the borrower will live.

Discount points. Borrowers who pay discount points can lower or “buy down” their interest rate. A point is an upfront fee equal to 1 percent of the loan amount. How much one point or a fraction of a point will buy down a borrower's rate depends on the lender’s pricing.

Closing costs. Many borrowers don't want to pay closing costs when they obtain a new loan. In that case, the lender can pay the borrower’s costs and adjust the borrower’s rate to offset those amounts. This lender rebate, sometimes called "negative points," results in what seems to be a no-closing costs loan. However, the costs are reflected in the rate instead of being paid out of the borrower's pocket at closing.

What they can’t use: Federal law prohibits discrimination in mortgage lending based on gender, race, ethnicity, national origin, religion, familial status or disability. Lenders are not allowed to use any of those factors to determine a borrower's interest rate.


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