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How Do Lenders Determine the Mortgage Rate They Approve You For?

The UpEquity Team Nov 17, 2021
How Do Lenders Determine the Mortgage Rate They Approve You For?

If you’ve been looking at purchasing a home and applying for a mortgage or refinancing your current mortgage, you might have noticed a few odd things. For one, interest rates can vary significantly from one lender to another. Mortgage rates also vary by state and from one day to the next. So, it’s not surprising that many buyers get number-fatigue when shopping for a home loan, and it can be tough to navigate the market rates with so many moving pieces. Still, it’s imperative to understand how interest rates factor into your loan pricing and how lenders determine the rate they approve you for.

Check out this guide for a quick crash course that could save you money on a new mortgage.

How Banks Determine What Mortgage Rate You Will Be Approved For

Typically, the strength of the U.S. economy sets the overall tone for mortgage rates. Mortgage rates have been at historic lows lately, making it a great time to purchase a home. However, the interest rate you’ll receive will depend on a variety of factors. While shopping for mortgage rates, you’ll find that different lenders will offer you different mortgage rates—even though you provide them all with the same information. In brief, lenders have different appetites for risk and overhead costs.

That said, here are the two items virtually all lenders use to determine your mortgage rate.

1. Credit Score

Banks use your credit scores to understand your past credit history. For the most part, consumers with higher credit scores get better mortgage rates. A high credit score communicates that you're a good risk—you pay your bills on time and are careful not to overextend your credit. In essence, you carry a lower risk of default. The lower your score, the harder it will be to find a lender that will approve you for a loan. And if they do, the interest rates will be marginally higher.

Although there isn’t a fixed cutoff for what constitutes a good credit score, lenders tend to offer the best interest rates to consumers with a credit score of 740 or higher.

2. Down payment

In other words, how much skin do you have in the game? A larger down payment means a lower interest rate because lenders view it as you being invested in the home. A down payment of 20% or more means you stand a better chance of receiving lower interest rates. The less money you put down, the higher your loan-to-value ratio, which is a higher risk for the lender.

If you aren’t ready to put 20% down, you can secure lower interest rates by agreeing to purchase private mortgage insurance (PMI), which protects the borrower in case you stop paying.

It's important to note that PMI will likely increase your total cost to borrow, even with a lower interest rate. Make sure to factor in all the costs of your loan, rather than just the interest rate, to avoid costly surprises down the road.

What Qualifying Ratios Do Lenders Use, and Do They Determine Your Mortgage Rate?

Qualifying ratios are the measuring devices lenders use when deciding whether to approve your mortgage application.

Your debt-to-income (DTI) ratio is a crucial measuring stick. Your DTI is a percentage that indicates how much of your total monthly income goes towards debt payments. There are two types of DTI ratios lenders evaluate:

  • Front-end ratio – shows what percentage of your monthly income goes towards housing expenses like mortgage payments, property taxes, and homeowners association fees, if any. It’s also referred to as the housing expense ratio.
  • Back-end ratio – gives a more high-level view of your financial profile since it covers all debt obligations, such as student loans, credit cards, auto loans, and child support, in addition to your monthly housing expenses.

Generally, lenders prefer a front-end ratio of 28% or less and a back-end ratio that’s no higher than 36%. Any percentage higher than 43% categorizes you as a risky borrower, and you're unlikely to qualify for a home loan, even with a great credit score. A high DTI indicates that you cannot afford to take on any debt. Banks want to lend money to homeowners with a low DTI, which increases their chances of qualifying for low mortgage rates.

What Are the Key Factors That Lenders Use to Determine an Applicant’s Mortgage Rate?

Lenders offer widely different rates to different applicants. Other key factors lenders might consider when pricing your interest rate include:

  • Employment type and income – employers might see self-employed individuals as posing a higher risk. Whether you're employed hourly or receive bonus-based pay will also be considered in evaluating your ability to pay back the loan.
  • Loan size – if you're requesting a loan under a certain amount (maybe $100,000, depending on the lender), there may be a slight increase in your interest rate.
  • Loan type – fixed, variable, adjustable, or balloon. Different loan types have varying rates because the risks differ.
  • Length of term – in most cases, you’ll get better rates on shorter loans since you’ll be paying back the debt quicker.
  • Co-borrowers – are there other people on the loan, and if so, what do their credit and DTI ratio look like?

Does Credit Impact the Type of Mortgage You Get Approved For?

Loans insured by the Federal Housing Administration (FHA) and the U.S. Department of Veterans Affairs (VA) have different score requirements compared to conventional loans.

You don't need perfect credit to get a mortgage. A credit score of at least 620 should qualify you for a conventional mortgage. But you can qualify for a mortgage even with a credit score in the 500s—depending on the type of loan you're going for.

Now You Know

An interest rate is simply a reflection of risk. When the borrower has a higher risk profile, the lender will demand a higher rate of return to offset this risk. Many factors go into determining your mortgage rate, with your credit score, down payment, and DTI ratio being the most important. By understanding these factors, you'll be well-armed when shopping for the right mortgage loan.


Here are some FAQs on Mortgage Loan Approval Process and Mortgage Rates

Do lenders use your employment history to determine the mortgage rate they approve you for?

It's unlikely for your employment history to influence your mortgage rate, but it can determine whether you get approved in the first place. Lenders vary on this, but they usually like to see some indication of financial stability. A longer work history means you're less likely to lose the job and stable income.

If you give a higher down payment, will you get a lower mortgage rate?

Yes. Lenders see a lower level of risk when you have more stake in the property, which can increase your chances of getting a lower mortgage rate. The golden rule is to put 20% down, as this will make you more appealing to lenders.

What is the max debt-to-income ratio that a lender will qualify a new mortgage?

When applying for a mortgage, the lower your DTI ratio, the better. It means less of your income is tied to recurring debt payments, which means you present less risk to the bank. Ideally, most lenders prefer a DTI of under 36%. You can still qualify for a loan with a higher DTI of up to 43%, but the loan terms will be more stringent.