Here’s how to better understand the rate and how to use it:
What’s in a mortgage rate?
Mortgage rates are based on two main factors: (1) how much it would cost the lender to acquire the funds you need to buy your home and (2) the risk you represent.
The first part of the pricing equation — the “cost of funds” is relatively easy to track. The pricing for mortgages generally tracks with the yield on the 10-year U.S. Treasury bond. As yields decrease, mortgage rates decrease; as yields increase, rates increase.
The second factor — the risk premium — is where home buyers should focus. This is where lenders assess a potential borrower’s ability and reliability to pay back their loan. And that’s where the credit score and other factors come into play.
Are you a risky investment?
If a home buyer takes out a $250,000 loan for a house, the lender wants to make sure it is going to get the money back. And in today’s mortgage market, where most lenders take your loan and sell it to another entity to be packaged together into a mortgage-backed security, the weight of the borrower’s responsibility grows — not in dollar value, but in impact. This is because there are now multiple players depending on the borrower’s ability to pay back the loan.
First, the lender gauges your ability to afford the loan. This assessment is typically based on a variety of factors, including your credit score, size of down payment and income, to name a few.
Sometimes when a person’s credit score is just too low or their income isn’t high enough, the lender will simply reject the loan application. In other cases, the lender may be willing to grant the loan, but at a higher interest rate that serves as a “risk premium” to protect it from the greater chance of default. In this scenario, the good news is you can move forward in the home-buying process, but it’s important to consider how that higher rate will impact your overall budget.
What’s the true impact of a risk premium?
Even what seems like a slight decimal change in your rate can mean real money. Someone borrowing $250,000 at 3.5 percent over 30 years will have a monthly principal and interest payment of $1,123. If the lender increases the rate by just 0.25 percent for additional risk protection — bringing the rate to 3.75 percent — the borrower’s monthly principal and interest payment will total $1,158. Thirty-five extra dollars a month doesn’t sound too bad, but over a 30-year mortgage, that equates to $12,600 in additional payments over time.
So what can a prospective home buyer do?
There are several important steps to take:
- Make sure the information your lender has is correct. Pull your credit report as soon as you start the home-buying process and make sure everything is accurate. You can go to annualcreditreport.com for free access to all three of your credit bureau reports.
- If you have high balances on any of your credit cards, consider paying them down — you generally don’t want any credit card to have more than 30 percent of your total credit available being used.
- Hold off on opening a new credit card for a while — new accounts can temporarily hurt your credit score. Consider a “consumer-permissioned-information” option for your credit report. In these are programs, consumers allow a bank or credit-reporting agency to see the information in their bank accounts, giving lenders more information about cash flow and allowing them to make better decisions. These programs help consumers by giving more information to lenders to help them more fully assess a potential borrower, beyond just the information in the application or in the credit report.
- Keep paying your bills — a missed payment, especially a recent one, can really hurt your credit score. Be vigilant about your budget in the months leading up to your application, prioritizing those essential bills.
- Talk to your lender and see if it uses a program that gives a lender access to your bank accounts so it can get a more complete picture of your financial situation. Depending on what your records show, this additional data can improve your credit score. And a higher credit score can translate to significant savings when buying a home.
Ultimately, your mortgage rate will influence your purchase — viability, cost, location, size and more. Being mindful of your credit score isn’t a one-time exercise, but rather an ongoing practice.
The more you are in tune with your credit and the factors affecting it, the more you can take steps to improve your credit and your mortgage options the next time you buy a home.
Francis Creighton is the president and CEO of the Consumer Data Industry Association based in Washington.
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