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Lending institutions make money by fronting you cash for a purchase and then charging you a little extra until you can pay them back. This is the basic definition of an interest rate. Interest rates vary depending on many factors, from the type of loan your applying for to your personal credit history. For example, an unsecured loan, such as a credit card, has a really high interest rate because there is nothing for a bank to take back if you fail to pay. A secured loan has a much lower interest rate as you have the item you purchased as collateral. Secured interest rates can also be higher depending on the perceived
necessity of the purchase. For example, the interest rate for a car tends to be lower than one for an ATV.
Your mortgage is likely the biggest loan you will have in the course of your lifetime. Not only are mortgages large, they’re paid off over a much longer period of time. A difference as small as a quarter of a percent can mean hundreds or even thousands of dollars paid (or saved) over the life of the loan. Have you ever wondered how interest rates are determined? How often do they change? How much control do you have over what you’re charged? How do FHA interest rates compare to conventional financing? This article will answer these questions and help you understand how lenders arrive at the amount of interest they charge.
What are Interest Rates
If you borrow money, you pay interest on that loan. If you lend money, you earn interest. When you buy a car, you pay the bank interest because they paid for the car and are allowing you to pay them back over the course of a pre-determined period of time, called the term of the loan. The longer the term, the more interest you pay. If you put money in a saving account, or a certificate of deposit, you earn interest because you’re loaning money to the bank for them to invest. When you apply for a mortgage, the bank is essentially taking a bet. They are gambling on whether or not you’ll pay them back in good faith. If the bank thinks you’re a good bet, they will charge you a lower interest rate. If they decide you are a riskier investment, your interest rate will go up accordingly. It all comes down to how much of a credit risk you are.
A High-Level Look at Interest
An FHA loan provides the lender extra protection by way of insurance. If someone fails to pay the mortgage on their home, that home goes into foreclosure. If your mortgage company paid out $250,000 on a house, and it goes into foreclosure with $200,000 still owed on the loan, the lender is out that amount of money. Even if they are able to sell the house as a foreclosure, it’s still a potential loss of over $100,000. Obviously, that’s not good for business. However, if the loan is an FHA loan, the lender can put in a claim with the Federal Housing Administration to cover that loss. Having this to fall back on reduces the risk to the bank, and gives you a way to mitigate circumstances that may cause you to be viewed as higher risk
How Does an FHA Mortgage Help?
An FHA loan provides the lender extra protection by way of insurance. If someone fails to pay the mortgage on their home, that home goes into foreclosure. If your mortgage company paid out $250,000 on a house, and it goes into foreclosure with $200,000 still owed on the loan, the lender is out that amount of money. Even if they are able to sell the house as a foreclosure, it’s still a potential loss of over $100,000. Obviously, that’s not good for business. However, if the loan is an FHA loan, the lender can put in a claim with the Federal Housing Administration to cover that loss. Having this to fall back on reduces the risk to the bank, and gives you a way to mitigate circumstances that may cause you to be viewed as higher risk.
FHA Loan Rates vs. Conventional Loan Rates
At first glance, it may seem that FHA interest rates are higher than conventional financing. This is usually not the case but will take some explaining. If you do a general search for ‘current interest rates’ or something along those lines, the rates you see are for someone with excellent credit. If you are able to put down a 20% down payment and have excellent credit, it’s possible that conventional financing might be the better choice for you. If, like many, you only have enough saved up for a 5% down payment and have a couple of late payments in your past, your interest rate for a conventional mortgage will go up. And often, it will go higher than the standard FHA interest rate, which doesn’t have as many penalties associated with lower credit scores. It seems complicated, but your mortgage broker will take a look broad look at your finances and help you determine which loans get you the best rate.
-Interest Rate vs. Annual Percentage Rate (APR)
Have you noticed that whenever you’re given the interest rate on a loan, they also give you a separate annual percentage rate? This is one of the most confusing things for consumers to comprehend. It helps to think of it like this:
· Your Interest Rate is the per year cost
to borrow money from the lender. It doesn’t matter if the rate is fixed or adjustable, and it does not include other fees charged to you by the lender.
· The Annual Percentage Rate (APR) includes the interest
rate, broker fees, points you choose to pay, and other items charged to
you to get the loan. The APR is almost always higher than the interest
Your monthly mortgage payment is determined by the interest rate and the balance of the loan. The APR includes fees charged by a lender, which makes the APR a much better tool when shopping around for loan rates. If while comparing lenders you notice the interest rate is the same, but the APR is higher at one, that means the one with the higher APR is charging more for the loan. The federal government enacted the Truth in Lending Act as a way to protect consumers from unlawful credit practices, so be sure to ask lenders what they include in their published annual percentage rates. They are required to tell you.
What Determines Your Rate?
Even taking into consideration the relaxed guidelines, mortgage lenders still need to assess your overall creditworthiness when determining your interest rate. Following are four factors that will affect your individual interest rate.
Sometimes it must feel like you live and die by your credit score. It has great influence on your financial options throughout life, so if at all possible, guard it well. Your credit score is a three-digit number that represents how well you have handled your finances in the past. Depending on several factors, such as your payment history, amount of unsecured debt (i.e. credit cards) and overall debt load, you are assigned a FICO score. The lowest credit score available is a 300, and the highest is 850. A score over 670 is good, over 740 very good and over 800 is exceptional. The higher your credit score, the lower your credit risk. Therefore, you would qualify for a lower interest rate.
Most often the more money you put down on your property the lower your interest rate will be. This is because banks see that you have a higher stake in keeping the property and taking care of the investment. That being said, the number one reason people usually opt for an FHA loan is the ability to only put down 3.5% and still get a decent interest rate.
Not only is there nothing wrong with that, it often makes better financial sense than throwing away $2,000 a month on rent and getting nothing in return. That doesn’t change the fact that if you have enough cash on hand to put 20% down and decent credit, your interest rate will be lower with conventional financing.
Amount of the Loan
The larger the loan, the bigger the risk your lender is taking. This is why an FHA jumbo loan will have a higher interest rate than a regular FHA loan. A jumbo loan is any loan that exceeds the conventional conforming loan limits, which change based on your location. People that live in certain high-cost areas frequently need FHA jumbo loans out of necessity. After all, a 1,750 square foot house in San Francisco, CA is going to cost way more than it will in Fairbury, NE.
Type of Loan
The type of FHA loan you apply for will also impact your interest rate. Different loans have different rate structures. A fixed-rate mortgage will have a slightly higher interest rate to start off with compared to an adjustable rate mortgage, but you have the comfort of knowing that your payments will not change over the life of the loan. For example, a 5-year adjustable rate mortgage (ARM) starts off with a low initial interest rate period, but then rises based on certain indexes and margin costs. It’s possible that over the life of the mortgage, you’ll pay more overall interest with an ARM than you will with a fixed rate. However, if you do not plan on being in the home longer than 5 years, an ARM could be a great idea for you and save you interest in the short term.
As you can see, when it comes to interest rates, there is no one-size-fits-all solution. You can have three people riding the same bus – one with a conventional 30-year fixed rate loan, one with an adjustable rate FHA mortgage and one with an interest-only loan, and they’re all great decisions. The type of mortgage that’s best for you is one that gets you the house you want at a price you can afford. That what our team at Community First National Bank will do for you. We listen to what you need and work with you throughout the entire loan process. Give us a call at (855) 971-1050.
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