Our agents are sometimes asked, “Why are mortgage rates different?” It is important for borrowers to remember that mortgage rates and interest rates in general, are determined by different factors, so an understanding of how mortgage rates are determined will help to better understand how banks and mortgage lenders set interest rates.
Every loan scenario is different, with different amounts, different borrower credit scores, different types of housing etc. – dozens of variables - and each loan must be priced accordingly. The predominant factor in determining interest rates and prices, however, is the risk of default risk, which is called “risk-based pricing.” The higher the risk, the higher the rate.
Banks and lenders start with a base interest rate and then either raise it or lower it based on the loan criteria. These include loan amount, documentation (full, limited, or stated), credit scores, occupancy, loan purpose (purchase or refinance, and if there is cash out), Debt-to-Income Ratio, property type, loan-to-value, and so on. In recent years, for example, loans made on non-owner occupied properties, or loans to borrowers with low credit scores have defaulted at a higher rate than other types of loans, and thus the rates are higher. And loans that do not fall under the maximum mortgage loan sizes set by Freddie and Fannie are usually pegged at a higher rate, since those loans are not easily bought and sold in the secondary markets.
Our borrowers often come to us with an ad from a newspaper, TV, or radio. Any rates that we hear about in the media are usually a best-case scenario: owner-occupied single family home, a perfect credit score, a huge down payment, and a conforming loan amount. Few of our borrowers are perfect, and as a result, they’ll see different mortgage rates. And “different” often means higher depending on the factors listed above.
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