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How do Banks Decide upon the Rate for a Home Loan?
If you are shopping for a home loan, you of course want the best possible rate. This is a decision that you will live with for many years. How do the banks determine the rate they quote you in the first place?
And once you know how those rates are determined, is there anything you can do to get the best rate for your mortgage?
One of the most important factors, and one that makes the news all the time today, is your credit score. If you just talk to your neighbor about taking out a home loan, you will probably hear, "well, I hope you have a good FICO score."
If you have wondered what a FICO score is, it is a number that credit agencies assign to a person's credit status. Using the financial data of the borrower, such as payment record, job history, credit card and other debt, the score will help the bank decide how much to charge for the mortgage.
An important consideration also is the size of the deposit on the house.
First of all, you are putting your own funds into the project; this gives the bank confidence that you are confident enough in paying back the loan that you have committed sizeable upfront funds as a deposit.
Consequently, the higher the deposit you are willing to make, the better the rate will be deposit. In order to save for a higher deposit, the longer you may have to pay rent, so that tradeoff has to be considered.
The next factor that will be used to decide the rate is the length of the mortgage. If a bank has to commit for a longer period, they are going to price that additional exposure into the loan rate.
This is why you will typically see short term loans at a lower rate than a 25 or 30 year mortgage. The downside to this concept is that, if rates are on the rise, you will have to pay more each time you renew your short term mortgage, instead of having a steady rate for 25 years.
Which is what leads us to the next determinant for interest rates, one which you have no control over: the market. Since banks have to borrow on other markets in order to lend mortgage money, the cost of their money goes up and down. These market rates are set according to complex economic indicators.
Most people would rather take a chance on a fixed rate that can't go up, than a rate that changes periodically. Even if rates go down, they feel the risk is better to have a locked in rate than a fluctuating rate.
The size of your mortgage is the last factor used in determining rates. Banks are limited as to the size of their loan portfolio, and if your mortgage is sizeable, they will be adding a lot of risk to their portfolio and have to expect a higher return for that higher risk.
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