Why Is the Rate of Interest on a Home Loan Important?

Why Is the Rate of Interest on a Home Loan Important?
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When you begin to look for preapproval or prequalification for a mortgage to buy a house, you need to consider the amount you'll need for escrow, your monthly mortgage payment, origination fees and homeowners insurance. Also, you'll want to know how much money you have available to put into a down payment. Your loan officer, realtor and insurance agent can help you estimate these.

The mortgage payment must fit within the mortgage lender's guidelines, and you must be able to afford the payment within your budget. The interest rate on your mortgage is a major factor in the amount of your payment. Because of this, interest rates often have an effect on the real estate market in the form of home prices.

Let's look at the factors that determine the interest rate on a homeowner's mortgage.

Read More​: The Pros & Cons of Mortgages

How Do Interest Rates Affect Your Home Mortgage?

Let's suppose you're buying a house for $250,000 and are putting $25,000 as a down payment. At a mortgage rate of 3 percent, your monthly payment for principal, interest, property taxes and insurance with private mortgage insurance would be $1,230 - all due to the increase in your interest payment.

Now suppose your mortgage interest rate is 4 percent, not 3 percent. Your total mortgage payment goes up to $1,356, a difference of $126 per month. Clearly, you have lower monthly payments with a lower interest rate.

Lenders want your monthly mortgage payment to be no more than ​28 percent​ of your monthly gross income. If your mortgage payment is limited to 28 percent of your monthly gross income, your monthly income at a 3 percent mortgage rate must be $4,392, or $52,704 annually.

For a 4 percent rate loan, you'll need a monthly income of $4,843 or an annual income of $58,114 to comply with the ​28 percent​ front-end limit.

Let's look at this another way. What would be the effects of a 1 percent differential in the mortgage interest rate if your annual income is $52,000? At a 3 percent mortgage rate, you could afford to buy a house for $250,000 with a $25,000 down payment. If the mortgage rate goes up to 4 percent, the price of a house that you could afford on your income of $52,000 would drop to $225,000 with a down payment of $22,500. Use a mortgage calculator to run some scenarios.

Factors That Affect Mortgage Interest Rates

These are the factors that will determine the best mortgage interest rate on your loan:

Credit score

Your credit score has a major influence on your interest rate. In general, borrowers with high credit scores get lower interest rates. Lenders charge higher interest rates to borrowers with low credit scores.

Down payment amount

Lenders offer lower interest rates to borrowers who make larger down payments, especially if you put down ​20 percent or more​. Lenders view borrowers who make higher down payments as less risky because they have more investment in their property.

If you put down ​less than 20 percent,​ lenders require you to purchase private mortgage insurance (PMI). The monthly premium for PMI can be ​$100​ or more, depending on the loan balance as a percent of the loan amount.

Read More:What Is PMI?

Type of interest

You have a choice of two types of interest rates: fixed or variable. The most popular type of mortgage is the ​30-year loan​ with a fixed rate. With today's mortgage rates hovering in the historically low range of ​2 to 3 percent,​ it makes sense to lock in these low fixed rates for the long term. With fixed-rate mortgages, your monthly mortgage payment stays the same for the life of the loan.

An adjustable-rate mortgage (ARM) may start out at a rate even lower than current fixed rates. However, you have a higher risk because the interest rate is adjusted after the initial fixed period to current mortgage rates or another agreed-upon rate. This adjustment usually happens once per year. This means your monthly mortgage payment can increase, which might cause problems if your personal financial situation has deteriorated.

Because of the lower initial interest rates, ARMs make it easier for less creditworthy borrowers to qualify. Most adjustable-rate mortgages have ​30-year terms.

Lenders offer lower interest rates to borrowers who make larger down payments, especially if you put down ​20 percent or more​.

Loan terms

Mortgage loan products are generally available with either ​15-year or 30-year terms​. Mortgages with ​15-year terms​ usually have lower interest rates than ​30-year​ ​mortgages​, sometimes as much as a full percentage point in the annual percentage rate. However, shorter-term mortgages require higher monthly payments. This makes it harder to qualify and stay within the ​28 percent​ front-end ratio for this loan type.

The good news is that with ​15-year mortgages,​ you’ll build up equity in your house faster and pay lower total interest costs over the life of the loan, but your budget must be able to handle the higher mortgage payments.

What Are the Different Types of Mortgages?

There are mortgages available for homebuyers with excellent credit scores and even those with low credit scores and very little money to offer as a down payment.

  • Conventional Mortgages:​ Fannie Mae and Freddie Mac offer what are known as conforming loan options. The government does not back conforming mortgages, so this type of loan is more suited for homebuyers with strong credit histories. You need a credit score of at least ​620​ to qualify, but a score above ​740​ gets you the best rates. An attractive feature of these conventional loans is they have programs that only require a ​3 percent​ down payment. However, you still have to pay PMI if you make less than a ​20 percent​ down payment.
  • Federal Housing Administration (FHA)​​:​ The U.S. government insures FHA loans, making them virtually risk-free for lenders such as banks or credit unions. FHA loans are attractive for borrowers with very little money for a down payment and credit scores as low as ​580.​ You can make a down payment as low as ​3.5 percent​, but you’ll pay private mortgage insurance (PMI) for the life of the loan. An FHA fixed-rate mortgage can be used for first-time homebuyers or an existing home loan refinance.
  • Veterans Administration (VA) loans:​ The U.S. Department of Veterans Affairs guarantees mortgages made by private lenders, such as banks and credit unions, to members of the military on active duty or their surviving spouses. VA loans do not require a down payment and do not have private mortgage insurance. However, the VA does charge a one-time funding fee that can be paid upfront or included in the mortgage. Although the VA does not have a minimum credit score requirement, lenders can set their own standards for the debt-to-income ratio to determine the borrower's ability to repay the mortgage.
  • U.S. Department of Agriculture (USDA) loans:​ USDA loans are targeted at low-income homebuyers who are willing to live in designated rural areas. These loans do not require a down payment, but they do require private mortgage insurance. There are maximum income limits that vary by location.