How do Banks Decide upon the Rate for a Home Loan?

Filed in Mortgage Rates on Sep.07, 2009

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?

And once you know how those rates are determined, is there anything you can do to get the best rate for your mortgage?

The most critical determinant of the interest rate you will be quoted by the banks is your credit score. This is an issue that is in the headlines all the time, and everyone who is looking to buy 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. Using the financial data of the borrower, such as payment history, held, credit card and other debt, the score will help the bank decide how much to charge for the mortgage.

The next determinant that will influence your interest rate is the size of the deposit you are putting on the property.

The higher the down payment, the better the rate you will receive from the bank; this is because with a higher down payment, the bank has less exposure based on the value of the property.

This means that the bank can consider you a better risk and will lower your home loan rate. In order to accumulate a higher deposit, the longer you would have to pay rent, so that tradeoff has to be taken into account.

Another important factor in the determination of a loan rate is the maturity of the loan. When lenders commit funds for longer terms, they have to include a cushion into the rate.

This is why you will typically see short term loans at a lower rate than a 25 or 30 year mortgage. Despite this fact, many people prefer a longer, fixed term mortgage because they always feel that the rates over time will increase and the loan will cost more in the long run.

Which is what leads us to the next determinant for interest rates, one which you have no control over: the market. 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. These market rates are set according to complex economic indicators.

But just as rates go down as well as go up, many people would rather have a longer term fixed rate.

Another factor that has an influence on the rate of your mortgage is the size of your loan. Banks have limits as to the size of the home loans they can write, and anyone who requires a higher loan than that, even if they have the income to support it, will most likely pay a higher rate.

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