Anyone looking for a mortgage for a home purchase will need to come to grips with interest rates. This is a confusing area for many buyers but one you have to get an understanding of if you want to save money. When you take out a mortgage, the amount you have to pay back will consist of the loan amount, plus any interest charged through its term. These rates go up and down all the time but why? More importantly, what can you do to make sure you nab the best rate? Read on to learn about why mortgage rates fluctuate and what you can do to get the best rate.
Why Do Interest Rates Matter?
Mortgage lending is a business just like any other. Their goal is to make a profit and charging interest on your loan is how they do it. Interest rates are always calculated as a percentage of the loan amount you borrow. For instance, if you were to take out a 30-year loan for $200,000 with a 4% interest rate, you’d end up paying back that $200,000, plus an extra $143,739 in interest. In this example, your monthly payments would be $955. Each payment will consist of part of your principal (the amount you borrowed), plus the interest accrued for the month.
Your lender will use an amortization formula to calculate how much of your monthly payments will go towards the principle and the interest. The amount you pay in interest over the life of the loan will also be affected depending on if you choose a fixed rate or an adjustable-rate.
Fixed-Rate vs. Adjustable Rate
Most banks and lenders will offer two types of loans:
- Fixed-Rate – The interest rate does not change over the lifetime of the loan.
- Adjustable-Rate – The interest rate will change under defined conditions
If you take out a fixed-rate loan, this means the interest rate will be locked in for the entire duration of the loan. You’ll pay the exact same amount each month in interest which won’t change until the loan is paid off. This provides better stability and makes it easier to plan for the future. However, fixed-rate loans tend to come with a higher interest rate than adjustable-rate loans, at least at the start.
An adjustable-rate loan is when the amount you pay in interest changes over the lifetime of the loan. Lenders will usually offer a low rate that is fixed for a few years. Once that time limit is up, the rate will fluctuate at least once a year. These types of loans will have a limit on how much the rate will change as well as how often it can be changed. As it changes so will your monthly payments.
How do Rates Fluctuate?
Mortgage rates can change daily depending on the state of the economy. Numerous factors influence this such as consumer demand for housing and unemployment levels. During a slow economic period, the Federal Reserve will provide more funding which allows rates to go down. When the economy picks up speed there’s a fear of inflation so the Fed will restrict funding and interest rates will go up. Many factors influence this and it’s impossible to know when rates will fluctuate and by how much.
How do You Lock in a Rate?
The term “rate lock” refers to when a lender offers a guaranteed interest rate. This rate lock will last about 30 days and usually starts once you’ve been preapproved. If you can close on a home within that time, the rate is yours. This offers you protection against fluctuating rates and provides you with peace of mind of knowing how much you’ll be paying. Understandably, many buyers will agonize over when the right time to lock in a rate is. Unfortunately, there’s no way to predict where the economy will go and how rates will change. Instead of obsessing over small changes in interest rates, think about where you are in the home buying process.
Most lenders advise that the time to lock in a rate is the moment you’re in contract on a home. A 30-day rate lock should allow plenty of time to close on the sale and many lenders will offer to extend that to 45 days if you need more time. You may even get a “float-down option,” which allows you to get a lower rate if interest rates drop. Just be aware that this option comes with a number of conditions and costs depending on the lender.
How to Get the Best Rate
Your interest rate will depend on your personal finances. To get the best rate you can focus on the following factors:
- Credit Score – Your credit score plays a big part in determining your loan amount and interest rate. The higher your score, the more you can borrow and the lower your interest rate is. A perfect score is 850, a good score is between 700 and 759, a fair score is between 650 and 699. Get that score as high as you possibly can.
- Down Payment – The larger your down payment, the fewer risk lenders feel and the lower the interest rate is they can offer.
- Home Location – Interest rates are affected greatly by the state of the local housing market.
- Loan Type – What loan type you choose will also affect your interest rate. Conventional loans are the most common type and usually given out when you have solid finances. Those with less solid finances can take out an FHA loan, which allows for a down payment of only 3.5%. However, this will mean a higher interest rate.
- Loan Term – The shorter your loan term, the lower the interest rate. However, the shorter it is, the higher your monthly payments will be.
- Type of Interest Rate – If you choose a fixed-rate mortgage then you’ll have a guaranteed rate for the duration of the loan. However, this will usually come at a higher rate. An adjustable-rate loan comes with a lower rate in the initial period. But then it will start to fluctuate once the starter period passes (usually three, five, seven or ten years).