If you are shopping for a mortgage, you of course want the best possible rate. This is a decision that you will live with for many years. How do the banks determine the rate they quote you in the first place?
Understanding how interest rates are determined can help you in getting the best rate on your mortgage.
The single item that has the most influence on the level of the interest rate is the credit standing of the borrower. This is an issue that is in the headlines all the time, and everyone who is looking to purchase a home is concerned about their “FICO” numbers.
The idea behind a FICO rating is that private agencies do an analysis on a borrower’s credit profile to determine the chances that he will be able to pay the loan. Banks all use the services of these credit rating agencies to find out the assumed risk of lending to a borrower and the criteria the agencies use are history of payments, exposure to debt, income, job history, etc.
One of the most important factors that will influence a loan rate is the size of the down payment.
First of all, you are putting your own funds into the project; this gives the bank confidence that you are confident enough in paying back the mortgage that you have committed sizeable upfront funds as a down payment.
Consequently, the higher the deposit you are able to make, the better the rate will be deposit. It is always a difficult decision about waiting and saving for a larger deposit, while wasting money on rent that could go for a mortgage. But a higher interest rate can make your mortgage payments more than your rent, so think about waiting to accumulate a good.
The maturity of the mortgage is also an important component in the determination of the interest rate of the loan. If a bank has to commit for a longer period, they are going to price that additional exposure into the loan rate.
Taking a shorter maturity on your mortgage, such as a five year loan instead of a 25 year traditional loan will result in a lower rate for you. However, many people still prefer to negotiate a longer term loan if they can because they fear that interest rates will rise and they will constantly have to renew their mortgage at a higher rate.
This is one of the other important factors in what determines interest rates: What the general market is doing. If interest rates are going up in general, interest rates on mortgages will go up as well, since banks have to pay interest on the money they obtain. Whether interest rates will go up or down is a topic under constant study and discussion by economists.
This is why a lot of people choose to pay a higher rate for a longer term mortgage and forego the risk of having constantly rising increases in their mortgage payments. (The opposite could happen, where interest rates fall and you are stuck with a 25 year higher rate mortgage.)
A final factor is the size of your mortgage. Banks are limited as to the size of their loan portfolio, and if your loan is sizeable, they will be adding a lot of risk to their portfolio and will expect a higher return for that higher risk.
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