Multiple factors come into play in the way mortgage rates are determined. Some of these factors are related to policy, or they are influenced by the overall state of the economy, other factors are tied to your particular financial situation and the individual’s financial history.
We can say that some factors are economic, others are individual, and they all relate in various percentages to the way your lender determines your interest rate.
As a borrower in the FHA loan program, you’re naturally interested in all the factors that contribute to how FHA loan rates are determined, which is why you’ll find that my article on this topic offers a helpful insight into how lenders determine FHA mortgage rates.
You’ll also know which factors you should focus on if your goal is to get the lowest rate on your FHA loan.
Determining FHA Mortgage Rates
Typically, FHA loan rates are higher than your average conventional loan rates because of the way these loan programs are structured (e.g. they allow a 3.5% down-payment, have lower credit score requirements, etc.), but this doesn’t mean you can’t get a good FHA loan rate if you’re a well-qualified borrower.
Regardless of whether we’re talking about conventional mortgages or FHA-backed mortgages, there are common factors that will affect mortgage rates.
In the grand scheme of things, policies issued by the Federal Reserve, industry trends, the state of the economy, investor demand within the stock market are all factors that will shape the way lenders determine mortgage rates.
I call these extrinsic factors, because they are beyond your control, yet they have a say in the average rates charged by lenders on any given day.
If you want to monitor the weekly FHA mortgage movement, I recommend that you watch the 10-year Treasury bond yield, which is a good indicator of how mortgage range interest rates change over time.
Even though 30-year fixed home loans are the most popular home financing construction, in practice, most borrowers will pay off or refinance their homes sooner than 30 years (usually in 10 years).
Treasuries are of course backed by the government and repayment is guaranteed, which isn’t the case with mortgage-backed securities, which have higher set rates precisely because they carry a higher risk.
So, while 10-year Treasury bond yields and mortgage rates do tend to mirror each other’s movements, the latter ones are riskier and hence carry higher rates.
As I mentioned, these are the extrinsic factors that will have a say in how conventional and FHA mortgage rates are determined, but there are also intrinsic or individual factors that will shape your FHA interest rate should you want to apply for a home loan within the FHA program.
Thankfully, you can actually influence these individual factors as they’re related to your financial history and past behavior, which is why you should focus primarily on these if you want to get the lowest possible rate on your FHA loan.
Let’s see the individual factors that shape how your FHA loans are determined:
Factors that Influence Your Mortgage Rates
There are two categories of things that will shape your interest rate — whether you’re perceived as a high-risk borrower or a well-qualified borrower and whether or not you choose to pay any discount points at closing.
Lenders of any type of loan — conventional or FHA — use something called ‘risk based pricing’ when your mortgage rates, which essentially means that if you’re deemed by the lender as a high-risk borrower, your interest rate will be higher than if you’re deemed low-risk.
This type of pricing scheme is devised to offset the risk associated with borrowers that aren’t considered low risk. Discount points can also be used to lower the interest rate of an FHA loan.
But without further ado, here are some actual factors that will shape your mortgage rate:
1. Your Credit Score
The three-digit number is a ‘window’ into your financial background. A high credit score signals to the lender that you’ve borrowed and repaid your loans in the past and there aren’t any issues they should be concerned about.
A low credit score, on the other hand, is an indication of some financial trouble (e.g. missed payments, delinquency, etc.) that will put you in the high-risk borrower category, provided that it won’t bar you from getting a loan in the first place.
A borrower with a credit score below 500 won’t even qualify for an FHA loan in the first place, and even with a credit score that’s in the high 500s, lenders may still want to see a higher credit score that’s somewhere north of 600 to consider you a qualified borrower.
Therefore, if your credit is bruised the lender will determine a higher interest rate to offset the risk associated with a borrower that barely meets the eligibility requirements of the lender.
Because a less-than-perfect credit has such an important bearing on the interest rate that you will receive from the lender, it’s important to make sure your credit score is in order.
An ideal credit score would be something above 760 if you’re looking to get the best possible mortgage rate from your lender.
2. Loan Amount
The FHA loan rate is also influenced by the amount that’s being borrowed, which is understandable. A higher amount will trigger a higher interest rate because a large amount represents a risk to the lender.
Naturally, a low, conforming loan will carry a lower interest rate since it’s not as risky for the lender as a non-conforming, ‘Jumbo’ mortgage.
Therefore, besides the credit score, the amount you want to borrow to finance your home will be a determining factor in the lender’s calculations of your FHA loan rate.
Of course, if you must get a certain amount to finance a home, there’s no other way to reduce the loan amount than to perhaps find a cheaper home.
3. Amount of the Down-Payment
One of the benefits of an FHA loan — and a reason why many borrowers choose this type of loan — is the low down-payment requirement that is just 3.5%.
Compared to conventional loans, FHA loans allow a lower down-payment, however, that will be reflected in the interest rate, which is usually higher compared to conventional mortgage rates.
When putting down a higher down-payment, lenders will perceive it as you have more stake in the property, which means a lower risk for them and a lower mortgage rate for you.
If you can put down a down-payment of more than 20%, you should definitely take advantage of it, but you should then also opt for a conventional loan, which carries a lower mortgage rate anyway since you won’t need to pay the insurance premiums that FHA loans carry.
In summary, a borrower with an FHA loan and a down-payment of 3.5% will have a higher mortgage rate compared to a borrower that uses and conventional loan and has a 10%-20% down-payment.
4. Loan Structure
Another factor that will determine the amount of your loan rate is the structure of your loan, namely whether it’s has an adjustable rate mortgage or a fixed one.
Fixed-rate mortgage — even if it’s for a longer period — are usually associated with a higher rate compared to adjustable rate mortgages, at least initially.
Therefore, this is something else to consider if you’re willing to opt for an adjustable-rate mortgage to save money initially by receiving a lower FHA loan rate, or whether you’re not going to risk your ARM increasing over time, and you decide on a fixed-rate mortgage.
5. Discount Points
Discount points are another way to lower your FHA loan rate by offering to pay discount points at closing. You can think of discount points as prepaid interest, where 1 discount point is 1% of the base loan amount.
By paying more money up-front, you can receive a lower rate, which can save you money in the long run. This strategy works out best if you’re offering to pay discount points for long-term stay.
6. Other Factors
Other factors like a favorable debt-to-income ratio (ideally less than 35%) will also influence whether you’re regarded as a high-risk borrower or a well-qualified borrower instead.
Lenders will typically advertise their loans by highlighting the lowest possible rate they’re willing to advertise, you even though you would qualify for an FHA loan, you may not get the same rate because of individual factors that put you in the high-risk borrower category.
In Summary…
Extrinsic factors related to industry trends and the economy will determine the average rates that lenders offer, while individual factors will determine the exact rate you will receive.
And as you can see above, there are a few areas that are within your control or depend on you (e.g. credit score, DTI, down-payment amount, etc.).
A well-qualified borrower will typically enjoy lower rates, because they represent a lower risk to the lender, while high-risk borrowers are ‘sanctioned’ with higher rates precisely because of the potential risk they carry for the lender.