It can be intimidating to talk about interest rates with lenders - it's a little bit like driving toward an unknown destination.
So before you set out, you'll want some guideposts in place, information to help you understand how lenders determine interest rates and what steps you can take to secure the best rate possible.
Why? Because a lower rate, even dropping one-quarter of a percentage point, could save you thousands over the life of your loan.
How Much Could You Save?
Say you're buying for a home for $250,000 with a 30-year fixed-rate mortgage and plan to make a 20% ($50,000) down payment. With an interest rate of 4%, your estimated monthly mortgage payment (excluding property taxes and homeowners insurance) would be $955 and you'll pay $143,739 in interest over the life of the loan (30 years).
Using the same purchase price and down payment, but with an interest rate to 4.25%, just a quarter of a percent higher, your monthly mortgage payment would go up to $984, and over 30 years you'll pay $154,197 in interest, over $10,000 more.
At 5%, one full percentage point higher than the first scenario, your monthly mortgage payment would rise to $1,074 a month, and you'll pay $186,512 in interest on the 30-year loan, over $42,000 more.
Those numbers show why it's important to compare interest rates from several lenders and find the best fit for your needs.
The Interest Equation
Lenders set interest rates based on several factors – some of which you can influence and others you can't.
The most important factor you have control over is your credit score. Your credit score helps lenders determine your credit-worthiness or, in other words, how likely you are to repay your debts. Typically, the higher your credit score, the lower your interest rate.
If you don't know your credit score, which ranges from 300 to 850, find out. There are many resources that will provide you with your credit score or report for free such as www.annualcreditreport.com.
If your credit score is on the low side, you can take steps to improve it. You'll want to start this process long before contacting mortgage lenders, because it can take some time to see a change in your credit score depending on where you start and your end goal.
Mastering the Elements
The good news for home shoppers is that interest rates are often negotiable. In other words, you can ask lenders to match the rate quoted by another lender. You should also work with your lender to understand what you can do to lower your rate.
One option they may suggest is having you pay mortgage points (also known as discount points) to lower your interest rate. Points are fees paid directly to the lender at the close of your loan. One point costs 1 percent of your mortgage amount (or $1,000 for every $100,000). Essentially, this allows you to pay some interest upfront in exchange for a lower interest rate, and the cost may be tax-deductible. As a general rule of thumb, consider paying points if you plan to own the home for a long time.
Table: Home purchase price: $250,000, Down payment: 20%, Loan Type: 30-year fixed-rate
|Interest rate||Monthly Payment (excludes taxes and insurance)||Total Interest Paid over 360 months|
|Interest rate: 4.0%||Monthly Payment (excludes taxes and insurance): $955||Total Interest Paid over 360 months: $143,739|
|Interest rate:4.125%||Monthly Payment (excludes taxes and insurance): $969||Total Interest Paid over 360 months: $148,948|
|Interest rate: 4.25%||Monthly Payment (excludes taxes and insurance): $984||Total Interest Paid over 360 months: $154,197|
|Interest rate: 4.375%||Monthly Payment (excludes taxes and insurance): $999||Total Interest Paid over 360 months: $159,485|
|Interest rate: 4.49%||Monthly Payment (excludes taxes and insurance): $1,012||Total Interest Paid over 360 months: $164,386|
|Interest rate: 4.625%||Monthly Payment (excludes taxes and insurance): $1,028||Total Interest Paid over 360 months: $170,180|
|Interest rate: 4.75%||Monthly Payment (excludes taxes and insurance): $1,043||Total Interest Paid over 360 months: $175,586|
|Interest rate:5.0%||Monthly Payment (excludes taxes and insurance):$1,074||Total Interest Paid over 360 months: $186,512|