How is your mortgage rate determined?
Understanding this is crucial, as mortgage rates greatly impact the home loan’s overall cost and monthly payments.
Knowing the factors determining mortgage rates can help you make informed decisions about your mortgage.
This article will explain how mortgage rates are calculated, covering everything from credit scores to loan terms so you can be better prepared when shopping for a mortgage.
How is Your Mortgage Rate Determined?
Contrary to popular belief, not everyone gets the low rates advertised on websites.
Your mortgage rate is specific to your circumstances and may differ from someone else’s.
Your mortgage rate is similar to the cost of the loan.
Mortgage lenders use complex calculations to determine a unique rate for you based on several factors, including your credit score, credit history, income, debt-to-income ratio, loan-to-value ratio, etc.
In general, the factors that influence your mortgage rate can be divided into two categories: those you can control and those you cannot control.
Factors you cannot control:
- The overall state of the economy
- The Bank of Canada’s overnight rate
- Inflation
- Lending finance costs
Lenders use these factors to determine their base lending rate, the minimum rate they offer their most creditworthy borrowers.
This article will concentrate on the factors you can control, such as your credit score, income type, down payment, and property usage, which can help you get the best mortgage rate.
These factors determine your unique mortgage rate.
Before discussing these factors, it’s important to understand the difference between your mortgage rate and your qualifying rate.
The Mortgage Qualifying Rate (MQR)
The MQR is a tool used by Federally regulated financial institutions (FRFIs) to assess your ability to make mortgage payments if you experience financial difficulties.
Most non-federally regulated financial institutions have adopted this guideline in their mortgage eligibility assessment.
The mortgage qualifying rate or stress test was established to prevent borrowers from defaulting on their loans during a time of rising interest rates.
This rate is usually higher than the rate the lender will use to calculate your monthly mortgage payment.
Lenders require you to qualify at a higher rate to ensure you can still make the payments if interest rates suddenly rise.
Qualifying for a mortgage at a higher rate gives the lender peace of mind that you can still make the mortgage payments if interest rates increase over the term.
This is known as stress-testing your financial capability.
How Your Qualifying Rate is Calculated:
The main factors in determining your mortgage qualifying rate are the –
- Benchmark Qualifying Rate (5.25%),
- the buffer (2%), and
- your contract mortgage rate.
Your qualifying rate will be the higher of either:
- The benchmark rate of 5.25%
- Or, your contract mortgage rate plus 2% (buffer)
For example, if your contract mortgage rate is 3.1%, you will be qualified for a mortgage using the 5.25% benchmark because it is higher than your contract rate of 3.1% plus the 2% buffer.
But if your contract mortgage rate is 3.89%, your qualifying rate would be 5.89% (your new contract rate of 3.89% + the 2% buffer).
The benchmark rate of 5.25% accounts for risks that can arise from fluctuations in the wider economy, such as changes in the Bank of Canada rate, inflation, or Gross Domestic Product (GDP).
The 2% buffer ensures you can handle changes to your financial circumstances, such as a drop in income or an increase in mortgage interest rates.
The higher qualifying rate limits your borrowing power and makes it harder to qualify for a mortgage, as you are assessed at a higher interest rate.
Different Borrowers, Same Lender: Why Varying Mortgage Rates?
The truth is that mortgage rates are not given. They are earned.
The rate you receive is based on your earnings. If you receive a low rate, know it’s because you’ve worked for it.
Think of your mortgage rate as the cost of your loan.
Lenders use a combination of factors such as your credit, income, and property information to determine this cost, which is your mortgage rate.
These factors are unique to you, which explains why your mortgage rate could differ from other borrowers, even from the same lender.
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Mortgage Interest Rate: Key Influencing Factors?
Credit Score:
Your credit score is a crucial factor that affects your mortgage rate. It ranges from 300 (the lowest) to 900 (the highest).
Lenders use credit scores to evaluate your creditworthiness and ability to repay debt.
If your credit score is low, it suggests that you have not consistently paid debts and may be considered a high-risk borrower.
As a result, lenders may offer you a high mortgage rate to mitigate their risk.
On the other hand, a high credit score demonstrates that you are a responsible borrower and more likely to make payments on time.
A high credit score signals that you are a low-risk borrower who will likely repay your debts as required. In this case, lenders are more willing to offer you their best mortgage rates and favourable loan terms.
What is a Good Credit Score for a Mortgage?
No universally accepted credit score can be labelled as good or bad for a mortgage, as each lender has its standards.
Typically, borrowers with a credit score of 700 and over receive the most favourable mortgage rates, terms, and options.
If your credit score is between 600 and 699, you can still receive low mortgage rates and favourable options.
Still, your selection of mortgage deals may be limited, particularly for rental property and refinance mortgages.
A credit score below 600 is generally considered low for mortgage purposes, and borrowers with scores in this range are classified as alternative, subprime, or B-borrowers.
Loan-to-Value Ratio and Mortgage Rates:
Mortgage rates are also impacted by the loan-to-value (LTV) ratio, which refers to the amount of money borrowed compared to the property’s value.
For example, if you’re buying a house priced at $200,000 and have $15,000 for your down payment:
You will need to borrow $185,000 ($200,000 minus $15,000) for the mortgage.
Thus, your mortgage will be $185,000, and
the LTV ratio will be 92.5% ([$185,000 / $200,000] * 100%).
But if your down payment increases to $25,000, your loan amount will be $175,000 ($200,000 Minus $25,000), and your LTV ratio will be 87.5%.
- Mortgages in the 80-95% LTV range typically have some of the lowest mortgage rates in the market because they come with default insurance coverage, which protects the lender against potential default.
- Mortgages with an LTV of 65-80% have some of the highest rates. The LTV ratios are still considered high, and the lender has no default protection.
- On the other hand, borrowers with LTVs below 65% are seen as having low credit risk because the loan amount is small relative to the property’s value. They enjoy some of the lowest mortgage rates in the market, even with the added protection of default insurance.
Location of the Property:
The location of the house you are purchasing can also impact the mortgage rate you receive.
The location of the property affects its value and marketability of the property.
These factors will affect the lender’s ability to fully recover the loan balance and associated expenses if the mortgage forecloses.
The property’s appraised report and public records help lenders determine its market value and overall marketability.
Properties in urban and metro-urban areas with active real estate markets are generally considered less risky to lend on.
In contrast, properties in rural areas are considered riskier and may come with higher mortgage rates.
The Purpose of the Property:
How you plan to use the property may also impact your mortgage rate.
If you’re looking to buy a rental or investment property, you may face an additional rate increase of 0.1% to 0.25%.
Rental properties often have higher interest rates as there is a greater risk of foreclosure if the tenants don’t pay their rent or if the property doesn’t generate enough income to cover the mortgage payment.
Additionally, there’s a risk that the tenants may not properly maintain the property, which can impact its market value.
The Income Source
For mortgage purposes, income sources are classified as fully verifiable or non-verifiable.
Standard employment and income tax documents, such as employment letters, pay stubs, and tax return statements, can confirm fully verifiable income sources.
The income for salary employees is fully verifiable. Lenders prefer this type of income source because it is more reliable and less risky.
On the other hand, non-verifiable income sources cannot be confirmed with standard employment and tax documents, so they are less reliable and risky.
These are mortgage programs designed for borrowers with income from non-verifiable sources.
These mortgages come with high rates to compensate lenders for the added affordability risk.
The Interest Rate Type:
There are two options for mortgage interest rates – fixed and variable.
Fixed-rate mortgages offer consistent and predictable interest costs known from the start and will not change, even if market interest rates do.
On the other hand, variable-rate mortgages have interest costs that fluctuate with market changes.
When you opt for a fixed-rate mortgage, you are locking in the interest rate for the entire term of the loan.
Your monthly payments will not increase even if interest rates go up.
However, this also means that the lender takes on more risk as they commit to a fixed rate without knowing how market rates may change.
As a result, fixed-rate mortgages usually have higher interest rates to compensate for market pricing mismatches.
On the other hand, variable-rate mortgages often have lower interest rates compared to fixed-rate mortgages.
This is because the lender can adjust the interest rate to match market movements, reducing the mismatch in pricing.
The Length and Type of Mortgage Term
The length of time you agree to a lender’s mortgage rate is called the mortgage term.
This term can range from 6 months to 10 years. The longer the term, the longer the lender will take to receive their money back, resulting in more exposure to potential default.
As a result, the risk of not getting the money back increases as the term extends from six months to ten years.
Lenders typically charge higher rates for longer-term mortgages to compensate for this increased risk of default.
Conclusion
In conclusion, the mortgage rate you receive is determined by several factors.
Your credit score and income are two of the most important factors.
Still, other considerations, such as the property’s location, intended use, type of income, mortgage term, loan-to-value ratio, and mortgage term type, can also play a role.
Understanding how these factors affect your mortgage rate is essential to getting the best deal.
If you are in the market for a mortgage, consider shopping around and comparing rates from different lenders.
A platform like approvU Mortgage can simplify this comparison process and help you save money.
