Top Factors In Determining Your Interest Rate
As a home buyer, getting a good interest rate is imperative. It is one of the determining factors that will help you evaluate your home purchasing decision. Everyone hopes to get the lowest mortgage rate possible but only a few know exactly what dictates the rate. Read on if you want to learn what affects your mortgage rate.
What is Interest Rate?
Interest Rate is the cost of borrowing charged by your lender. The higher the rate, the more cost/interest you would have to pay. Lenders use the interest rate to calculate your monthly payment and the proportion of the monthly payment that goes towards your principal.
Your credit score is usually where it starts. It directly reflects how reliable you are going to be honoring the contract.
In general, the higher the credit score is, the lower the interest rate will be
In Canada, Equifax and Transunion are the main credit reporting agencies that most Canadian lenders rigorously follow.
Keep in mind that you can access your credit report for free once a year. Having a strong knowledge of credit reports will help you predict the likelihood of getting your desired mortgage. If your credit score is below the required line, you will need to make a plan to improve your credit score.
Employment Type and Income
Different employment and income types will affect how banks respond with mortgage rates. Generally speaking, those with stable-paying jobs can get lower interest rates than those self-employed. The reason being is that people with permanent positions are usually considered less risky and more secure in the eyes of the banks.
Loan - Size
Imagine your friend comes to you for a loan. You agree to lend the funds but expect interest in return. With all other factors being equal, would you quote a higher interest rate on a $1,000,000 dollar loan than a $500,000 one? Most people will say “ Yes” because the more the loan is, the higher the risk will be. You will understandably be expecting a higher return to compensate for your risk.
The ideology also applies to banks / almost any lenders. In general, the more money you are trying to borrow, the higher the interest rate your lender will be asking for.
Loan - Type
There are many different loan types you will run into when applying for mortgages. Each one is better suited for a specific situation. Lenders will decide which product to offer based on your situation and rates will change accordingly.
Length of Term
Different borrowing terms will also affect your interest rate because of:
- the varying opportunity costs
- underlying risks that lenders have to carry.
Let’s put this into perspective, imagine your friend comes to you for a loan and you are expecting interest in return. With all other factors being equal, would you quote your friend different interest rates based on different loan terms? How would you quote a 1-year, 3-year and 5-year term?
The rule of thumb is that the shorter the term is, the lower the rate will be. This is because a 1-year term will be less risky to the lender and also enable the lender to invest in other assets in a much shorter turnaround time compared to a longer-term.
Different property types will carry individual interest rates because each of them is associated with different levels of risk.
Level of risk :Vacant Land > Commercial Property > Residential Property
Mortgage Rate: Vacant Land > Commercial Property > Residential Property
The Loan to Value (LTV) ratio is an important determining factor to interest rate because it shows how much you have for a down payment and how risky you are as a borrower.
All chartered banks require at least a 20% down payment for an uninsured mortgage. The insured ones, however, can be acquired with as little as 5%.
Generally speaking, the more your down-payment is, the lower your LTV is and the cheaper you will get a mortgage.
To sum up, all determining factors to interest rate revolve around the risk associated with the particular deal. The riskier the deal is, the higher the interest rate the lenders will ask for. I would suggest you complete the mortgage self-check list before you contact the mortgage department. Opportunity favors the prepared mind!