Your mortgage interest rate has a massive impact on your overall financial health. Even a small fluctuation — such as 0.5% — can have repercussions of tens of thousands of dollars, since it’s multiplied over a large sum across many years. Here are five tips to help you secure the best mortgage rate possible.
1. Boost your credit score
A credit score can determine whether a lender will toss your mortgage application to the side or keep reading. Because credit scores show lenders your creditworthiness, the best mortgage rates tend to go to people with scores of 740 or above.
How can you improve yours? Five factors affect your credit score: your payment history (35%), length of account history (15%), recent credit applications (10%), types of credit used (10%), and credit utilization ratio (30%). In other words: Pay your bills on time.
Don’t open any new credit accounts within six months of your mortgage application, and keep your oldest credit card accounts open, even if you don’t use them anymore. Remember that installment-payment debts, like student loans, look better than revolving debt like a credit card balance.
Your credit utilization ratio is a measure of the amount of money you’ve borrowed relative to the amount you’re able to borrow. Keep this to no more than 20%. If your credit limit is $10,000, for example, carry a balance of no more than $2,000.
2. Improve your debt-to-income ratio
Lenders will also study your “front-end” and “back-end” debt ratios. Your front-end ratio shows the percentage of your pretax monthly income that goes toward your mortgage payment. This should be no more than 28%.
Your back-end ratio, also called your “total debt-to-income” (or DTI), shows the proportion of your income that goes toward all debt payoff, including student loans, car loans, and more. This should ideally be no more than 36%. To become a more attractive borrower, pay down other debts so that your DTI improves, and as a bonus, your credit utilization ratio may also improve.
3. Consider a shorter-term fixed-rate mortgage
Most borrowers consider a fixed-rate, 30-year mortgage. But if you’re able to swing higher monthly payments (often by buying less house than you can afford), you can snag an even lower rate by opting for a fixed rate, 15-year mortgage, which will offer interest rates as much as 0.8% lower than its 30-year counterparts.
Don’t let a 15-year mortgage scare you: You will not actually be paying double what you would’ve paid on a 30-year mortgage. A mortgage consists of four elements — principal, interest, taxes, and insurance — and the last two remain the same regardless of whether it’s a 30-year or 15-year loan.
4. Weigh fixed- vs. adjustable-rate mortgages
Alternatively, look at adjustable-rate mortgages (ARMs), which are typically “locked” for the first few years, with a cap on how much they can adjust afterward. For example, a 5/1 ARM locks in the interest rate for the first five years, usually at a rate that’s even lower than a 15-year fixed.
ARMs are ideal if you’re certain you’ll sell while the rate is locked, but be cautious: When home values fell during the recession, some people with ARMs suddenly became “underwater” (they owed more than the house was worth), which meant they couldn’t sell their homes as they’d originally planned. Moral of the story: If you have an ARM, make sure you can cover the higher payment when the loan adjusts — even if you don’t expect to still own the home at that point.
5. Pay for points
Most lenders are willing to collect money upfront in exchange for a lower interest rate during the life of the loan. These deals are called “points.” Each point is 1% of the borrowed amount, and the more you pay, the lower your interest rate. Typically, the longer you expect to hold the loan, the more it makes sense to pay for points. If you plan to sell the home, refinance the loan, or finish paying off the loan within the next decade, then paying for points becomes less of an attractive offer.
How did you land a great mortgage rate? Share your tips and experiences in the comments below!