You see that interest rates have dropped and a commercial catches your eye that advertises the lowest rate you have seen in a long time. You run over to the bank that advertised the rate with the high hopes that you will be able to get that rate and save a ton of money every month, only to have your hopes dashed. After completing your application and receiving the interest rate quote, you find out that you are not going to save nearly as much as you thought because your interest rate is much higher than you saw on the commercial. What’s the deal? Unfortunately, there are a lot of factors that play into the interest rate you receive. The rates you see advertised are just a general rate that only the people with the “perfect” conditions can qualify to receive. Unless you are among those perfect people, your rate will have some adjustments made to it.
Your Credit is Bad
One of the largest reasons that interest rates come back higher than you anticipated is your credit. The interest rates that are advertised are usually based on someone with “excellent” credit. This means someone with a credit score higher than 750. If your score is 749 or lower, there will automatically be an adjustment to your interest rate. If you want to see how your credit score falls into the mix, here is the breakdown that most lenders use:
- Credit scores between 700-749 = Good
- Credit scores between 650-699 = Fair
- Credit scores between 600-649 = Poor
- Credit scores lower than 600 = Bad
With each tier that you drop down in the credit ranking chart comes a higher adjustment. Of course, every lender has their own way of adjusting the interest rate. For example, one lender might adjust the quoted rate 0.5% for a fair credit score, while another might only adjust it 0.25%. It depends on your compensating factors or factors that make your credit score less of a risk for them. These compensating factors could be things like a large amount of assets or great stability at one job for many years, just as an example. No matter what your credit score is, it always pays to go to different lenders to see what they have to offer.
Your Loan-to-Value Ratio is High
If your loan-to-value ratio is high, meaning above 80%, there could be an adjustment to your interest rate. The higher your LTV, the higher risk you pose and the higher risk you pose, the more the lender needs to adjust your interest rate. Only the loans that pose very little risk to the lender get the advertised rate, so keep that in mind when you are considering the amount of a down payment to put down on the home you purchase. If you have the option to put 20% down, you have a higher chance of being able to obtain that low interest rate you saw. This is not to say that you have to put 20% down, but the more you can put down, the better off you will be. Every loan program has its own maximum LTV, but that does not mean that the lender wants you to take advantage of that number. For example, the FHA loan allows for an LTV of 96.5%, but if you have more money to put down than just the 3.5%, you should put it down in order to bring the risk level down. If you put down just 3.5% of purchase price of the home, you do not have a large investment of your own in the home. Let’s say that you are purchasing $200,000 home and you put down the 3.5%, which equals $7,000, and then you become unable to afford the loan in the future. It is fairly easy to walk away from $7,000 and put the home ownership thing behind you. On the other hand, if you had 10% invested, you would have put down $20,000, which would mean a larger investment of your own money and a harder time walking away from it if times got tough. This is why lenders adjust the interest rate in accordance with the lower down payments.
Your Debt Ratio is High
Your debt ratio also plays a role in your risk level. The more debts you have, the riskier you become. Every loan program has their own debt ratios that they allow. For example, the FHA loan allows debt ratios of 29/41. This means that you can have a 29 percent debt ratio on the front end or the amount of your mortgage payment that includes the principal, interest, taxes, and insurance and a 41 percent debt ratio on the back, which is your mortgage payment plus any other debts. If your debt ratio is right at those limits or slightly above, the lender will likely adjust your interest rate to make up for the risk level that you create. Every lender operates differently in terms of debt ratios, though; some adjust for debt ratios that are not near the limit, but still pose a risk to them.
The interest rate you are quoted is based on the overall picture you provide to the lender. They want to see how much of a risk you are to them, not based on one factor, but on many factors. As stated above, some factors can compensate for the negative factors you may have. For example, if you have a high debt ratio, but have 12 months’ worth of reserves on hand, you might be able to get away with not having an adjusted interest rate. It is really a subjective decision that the lender makes based on your entire financial picture. Of course, the better picture you can paint for the lender, the better off you will be in the long run when it comes to obtaining the lowest interest rate possible.