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How Do Lenders Determine Your Interest Rate?

December 12th, 2014 6:06 AM by Jackie A. Graves, President

interest rate

When you apply for a loan, you need to submit a ton of documentation and answer a bunch of questions from your lender.

Turning over all this information about your personal finances and financial history may seem intrusive, but it makes sense: The lender needs to gather all the information they can to decide on the interest rate for your loan.

But how do they take all your information and come up with a figure?

Balancing Profit and Competition

Lenders must strike a tough balance between being competitive with other firms and assessing the risk involved with loaning you money. If they try to charge borrowers too much, they’ll lose clients. However, if they charge too little, they’ll likely run into financial ruin.

Down Payments

There was a time when lenders would consider loaning money to borrowers who didn’t put any money down. This was extremely risky for the lender, because the borrower didn’t have a true stake in the home. There was a higher likelihood the borrower would walk away from their loan if they got caught in cash crunch.

Today, lenders look at down payments differently. If you’re willing and able to invest a large down payment in your home, the lenders assume less risk and will offer you a better rate. A 20% down payment makes a lender feel much more secure than a 10% down payment.

Credit Score

Credit score is another key factor in determining your interest rate. A high credit score shows you’re a responsible borrower, and lenders are more confident in loaning you large sums of cash with a lower interest rate.

If your score is low, the lender’s risk factor goes up. As a result the lender will charge you more to loan you money. If your score is too low, they’ll consider you a risk and decline your application.

Purpose of the Home

If you plan to live in the home, you’ll get a much better rate than if you plan to rent it out. Looking at it from a lender’s point of view, a person living in a house and making it into a home is much more likely to work hard to make the payments to keep the property.

A person who’s purchasing a house purely for investment may stop making payments if their financial situation worsens. It isn’t their home, so they aren’t emotionally invested.

Loan Type

There are many kinds of mortgage loans, and some are riskier for the lender than others. For instance, if you secure a 15-year loan, you’re agreeing to pay back the money faster than someone who opts for a standard 30-year loan. For this reason, lenders consider a 15-year loan less risky and are likely to offer you a better interest rate.

If you desire a fixed-rate mortgage, lenders will charge you more. They are guaranteeing you that rate, so they need to compensate for any risk.

By: Angela Colley | Updated from an earlier version by Laura Sherman.

To view the original article click here

Posted by Jackie A. Graves, President on December 12th, 2014 6:06 AM

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