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What Determines Your Interest Rate?

A common question asked by consumers is what items impact the interest rate on mortgage loans. We all know that interest rates go up and down. But why is it that after careful and intensive shopping of various lenders, do you end up with a disappointing high interest rate?

To answer to this question, we first have to understand that mortgage loans are investments, much like stocks and bonds. The interest rate on a mortgage loan represents the return on the investment. With any investment, the riskier the investment, the higher the return that is expected. Thus, the interest rate on a mortgage loan represents the perceived risk of the loan. The more the risk, the higher the interest rate. The less the risk, the lower the interest rate.

What is meant by risk? This means what is the possibility that the borrower will default on the loan? And if there is a default, can the property be sold for enough money to cover the unpaid principal amount of the loan as well as cover the selling cost of the property? Since no one can predict the future, the risk is based on historical analysis. History has shown that borrowers with certain characteristics are more likely to default. Certain types of transactions produce more defaults. Some types of properties are more marketable than other properties, thus producing more proceeds in a foreclosure sale.

The following are the major items (listed in order of degree of impact) that will effect the interest rate on a mortgage loan:

Lien Position

This relates to  whether the loan is a first mortgage or a second mortgage. Obviously, a first mortgage has less risk than a second mortgage. The difference in interest rate between a first mortgage and a second mortgage (all other items being the same) is as much as 2%.


Down payment/Equity

The larger the down payment/equity position, the lower the rate. 


Credit History

A borrower with a poor credit history will pay a much higher rate than a borrower with a good credit history. 


Investment Properties

Loan secured by investment properties are considered more risky, and thus carry a slightly higher rate.

Based on the above, a borrower with an excellent credit history, obtaining a first mortgage on his/her principal residence and with large down payment/equity will obtain the lowest interest rate.

There are other items that will impact the interest rate that are not loan risk related, such as the following:

LOAN TERM: Loans with shorter terms will have a lower rate. For example, a 15-year loan generally has a rate that is 3/8% to 1/2% lower than a 30-year loan.

LOAN SIZE: Large loans (over $417,000) generally have a rate at least 1/4% to 1/2% higher than loans less than $417,000.


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