Why Mortgage Calculators Can't Give You the Full Story
Why Mortgage Calculators Can’t Give you the Full Story
Mortgage calculators can definitely be useful tools and sometimes they are spot on, but a lot has to fall into place for them to be accurate. There are a LOT of moving parts when it comes to why you pay what you pay.
Your mortgage payment is made up of a number of components, boiled down to the acronym PITI – Principal, Interest, Taxes and Insurance. Principal is the amount of money you pay on a monthly basis that goes directly towards paying down what you actually borrowed from the bank. Interest is that percentage the bank charged you to obtain financing – you’re going to pay a substantial amount of money in interest over the life of your loan, which is why so many people are concerned about their interest rate. Every house has taxes – typically paid on a semiannual basis (frequency depends on the town). Then there is insurance – home owner’s insurance more specifically.
Some mortgage calculators attempt to take all of these factors into consideration. The majority that I have seen only estimate principal & interest. So first and foremost, be aware that there are more components to what you will pay on a monthly basis. Secondly, the interest rate used in these calculators is a hugely variable factor. There are SO many different factors that go into calculating your interest rate.
What is an interest rate?
I think most people are familiar with the basis of interest rates. When you borrow money (take out a loan), the person or institution you are borrowing that money from charges you a percentage called interest. But why is that percentage charged?
The short answer is that interest is the cost of doing business. The longer answer is that charging interest helps to mitigate risk. It’s an amount charged above and beyond what you borrowed. When someone lends you a large sum of money, there is always the risk that you won’t be able to pay them back in full (also known as defaulting on the loan). Charging interest creates a buffer, ensuring the lender doesn’t take a loss. And hopefully (for the lender), they actually make a profit.
Why is my interest rate so different from _____? (fill in the blank)
Interest rates are complex and take into account a number of different factors unique to both you and the current market. I originate mortgages for a wholesale brokerage which allows me to see what a vast number of lenders are willing to offer for one person’s “profile”. (I don’t lend you the money for your mortgage but I do match you with a lender who will lend you those funds). Every lender will evaluate your risk profile (your chances of defaulting) slightly differently. Which makes sense because all of these lenders have different business models and different markets they will want to focus on. On top of that, every person is in different situation financially. So now on to all the different factors that help to determine your interest rate…
This one is pretty straight forward. Loan size means the total amount of money you will be borrowing. Whether that be $90,000 or $700,000 – the final amount will impact your interest rate.
Loan to Value (LTV)
This is the loan amount compared to the total appraised value of the home. For example, suppose I tell you your loan to value is 95%. That means your loan amount totals 95% of the value of the home. In general, lenders view a lower loan to value as less risky. Intuitively this does make sense. Usually the way to achieve a lower loan to value is by putting down a larger down payment which would shrink your loan amount. This implies you have savings. Plus having a lower loan to value means you have more equity in the house, more assets to tap into if you needed.
This is a big one!! Credit scores are a HUGE determining factor in not only what your interest rate is, but whether or not you can even obtain a loan. Lenders have minimum credit score requirements but sometimes there are derogatory items on your credit report that can prevent you from obtaining a mortgage even if you meet the minimum score requirement (derogatory items include late payments, accounts in collections, foreclosures, bankruptcies, etc.). Generally, the lower your score, the higher your interest rate. Your credit report and account history provides lenders a road map to your financial responsibility. They use those credit accounts in determining how likely you are to make payments on your loan and to make those payments on time.
If your credit isn’t great or you are aware of derogatory items, don’t worry! A good mortgage loan originator will work with you to get you into a position where you can purchase or refinance a home. It might take a little more time, but we can make it happen!
(See: Why your credit score is so important for more details)
Debt to Income Ratio (DTI)
This ratio shows how much you pay per month in debts versus how much you make per month in income. It’s an important ratio because you need to be able to afford your debts and still have money left over for groceries, utilities, gas, etc. This can impact your interest rate if you have a higher DTI. For example, the Federal Housing Administration says your DTI is allowed to be as high as 55% if you are looking to take out an FHA loan. Meaning, at the end of your month, 55% of your income has gone towards paying bills such as credit cards, student loans & your mortgage. However, not every lender will accept a loan with a 55% DTI. If a lender does accept a loan with a 55% DTI, they may charge you a higher interest rate to get that loan. Let’s break it down…
You have more money going towards bills every month than someone who has a DTI of 20%. Therefore you are more risky when looking at the numbers. This doesn’t mean you will default, it just means there is a higher chance from a lender’s perspective. Think about it, who would you trust more to repay you in full – your friend who has one credit card that only has a $100 balance on or your friend who has an expensive new car, loads of student loans and credit cards with high balances?
In order to guarantee an interest rate for your mortgage, your loan originator needs to lock your loan. This is typically done for periods of 15, 30, 45 or 60 days at initial lock. The goal is to close your loan before that lock period expires so your lock does not need to be extended and so you don’t lose the interest rate you were originally quoted. On the lending side, the longer the lock period, the more risk to the lender so they are typically going to pay a little less for 60 day lock versus a 15 day lock. If you close your loan during your lock period, the lender must abide by that interest rate, regardless of what the market is doing. Longer lock periods present more time for the unexpected to occur. What if we hit a recession? What if the market crashes? Even small hiccups in the market could result in the lender losing money on your interest rate.
This concept is very similar to lock period. Loan term refers to the number of years you will be paying back your mortgage (most commonly 15 or 30 years although many other terms are available). The longer you are repaying your loan, the more risk that you will stop repaying. Plus that is all the more time for the market to perform poorly, which cuts into the lender’s profits. That’s why 15 year mortgages tend to present lower interest rates than 30 year mortgages. Think about it, would you rather your friend pay you back in a month from now or a year from now?
There are SO many different loan products and programs out there. There are VA loans which are specific to veterans, conventional first time home buyer loans which offer incentives to people purchasing homes for the first time, FHA loans which offer lower interest rates and work with lower credit scores. That is just a small sampling of the wide variety of products that are on the market. Every product is designed to meet a different need and the lenders that offer these products can create incentives on top of those products. All of these different products are going to offer various interest rates based on the goals of that loan program and how your situation fits with that product.
Loan purpose refers to what you are obtaining the mortgage for. Are you refinancing your home to lower your rate and/or loan term? Are you purchasing your first home? Are you refinancing an investment property and taking cash out to renovate the kitchen? All of these purposes impact your interest rate differently because they all present different levels of risk to the lenders who are willing to buy them.
Occupancy essentially means who will be living in the house. This might seem like a silly concept at first, but it hold strong implications for how likely you are to continue paying on your mortgage. There are three basic types of occupancy:
1. Primary – meaning you’re taking out the mortgage and you are planning on living in that house.
2. Secondary – you are applying for a mortgage for a second home where you will not be living at full time.
3. Investment – you aren’t planning on living in this house. Instead, you are looking to either rent out the house or flip it for a profit (hopefully).
Why does this matter? If push comes to shove, you are probably going to prioritize the payments on your primary residence over your investment property. Say you lose your job and can only pay one mortgage. Are you more likely to pay that mortgage for the house that puts a roof directly over your head? Or are you more likely to pay for the mortgage that puts a roof over your head on vacations during the summer (meaning your second home)? This risk factors into your interest rate.
While this is a big chunk of what goes into your interest rate, there are definitely more factors! Take the time to talk to your originator and learn why your rate is where it is. Maybe the big reason your interest rate is super high is due to a low credit score. If that’s the case, you can work on improving your credit and hopefully refinance into a lower rate down the line. Don’t be afraid to ask questions! Your home is probably going to be your biggest purchase, take the time to understand the details.
Just starting the mortgage process? Have questions on your current interest rate? Contact Us For More Info We would love to answer any of your questions today! We are here to help!
Generation Mortgage, LLC is a Licensed Mortgage Broker by State of Connecticut Department of Banking, NOT A LENDER OR CORRESPONDENT MORTGAGE LENDER; 1st Generation Mortgage, LLC is a Licensed Mortgage Broker by State of Massachusetts Division of Banking- MB21779; Licensed Mortgage Broker Florida. To verify status of our licenses please visit www.consumeraccess.org and enter our NML number: NMLS 21779