Reader question: “I’ve been spending a lot of time on real estate forums lately, because I’m planning to purchase a home soon. It seems like the mortgage rates people are getting are all over the board. Sometimes the reasons for this are not very clear. How do lenders determine what mortgage rate I will get?”

For the average borrower, the factors that influence mortgage pricing are something of a mystery. How does the bank decide where to set their “baseline” rates? How do they decide who gets charged less interest, and who gets charged more? And why do they charge more for certain types of mortgage products, when compared to others?

In this tutorial, we will discuss some of the most important factors lenders use to determine mortgage rates.

The short answer: Lenders often use risk-based pricing when assigning interest rates to home loans. In this model, a riskier borrower will be charged a higher rate than one who poses less of a risk.

Risk can be measured in a number of ways. For instance, a borrower with a low credit score, a high debt-to-income ratio, and a relatively small down payment will pose a larger risk to the lender — when compared to a borrower with excellent credit, low debt, and a larger down payment. This is partly how lenders determine mortgage rates.

How Lenders Use Risk to Determine Your Mortgage Rate

In the mortgage world, risk is measured by the probability that a borrower will default, or stop paying, on his or her loan. This kind of risk is influenced by two primary factors: (1) the characteristics of the loan itself, and (2) the characteristics of the borrower who will take on the debt obligation.

Generally speaking, loans that are deemed riskier by the lender will end up being more costly to the borrower. The lender will charge a higher mortgage rate to compensate for the higher level of exposure.

Note: Risk-based pricing is not the only model for determining mortgage rates. There are others, such as the cost-plus and price-leadership models. We will focus on risk-based pricing in this tutorial, since it is most relevant to borrowers.

How does the lender determine your mortgage rate? They typically start with their best (lowest) rate, and then mark it up to account for increased “layers” of risk.

  • Low risk: Borrower ‘A’ has an excellent credit score, very little debt, and a 20% down payment. She represents a low risk to the lender, so they probably won’t mark up her mortgage rate. It will remain at the lowest level, where they began their pricing calculation.
  • High risk: Borrower ‘B’ has blemishes on his credit report. His score is barely high enough to qualify for a loan. He has a lot of debt, in relation to his income. He can only afford a down payment of 5%, for an LTV of 95%. The lender will mark up his mortgage rate to account for these added layers of risk.

Unfortunately, we cannot say exactly how much a lender will mark up the interest rate for certain risk factors. It varies from one company to the next. There is no industry-wide standard.

Credit scoring is a key component of risk-based pricing models, especially where home loans are concerned. Because they are based on historical information found within your credit report, your credit score shows how you have borrowed and repaid money in the past. The lender will use your credit score to determine your mortgage rate. It’s not the only factor they will use — but it tends to “weigh” the most where interest rates are concerned.

Credit-scoring systems have been used and refined for decades. Today, they are a fairly accurate predictor of a person’s likelihood to default, or stop paying, on a loan. There is a well-documented relationship between the two.

In plain English: People with lower scores are more likely to fall behind in their mortgage payments, and are therefore charged more interest. They also have a harder time qualifying for loans.

Let’s recap. How do lenders determine your mortgage rate? They typically start with a baseline or default rate, and then apply mark-ups to account for various risk factors. The credit score is one of the most widely used, and useful, risk-analysis tools. It is the lender’s go-to resource for measuring a borrower’s risk. Debt levels and down payments are also used for loan pricing and rate assignment. Consumers with lower credit scores, higher debt levels, and smaller down payments are typically charged more in interest.

According to the Federal Reserve Bank of Minneapolis:

“Banks that use risk-based pricing can offer competitive prices on the best loans across all borrower groups, and reject or price at a premium those loans that represent the highest risks.”

Other Pricing Factors: Down Payments, Points, Loan Types

We’ve spent a lot of time talking about credit scores, and how they relate to the mortgage rate you receive from a lender. The importance of this factor cannot be overstated. But there are other factors that play a role here, as well.

Your interest rate will also be determined by:

  • the size of your down payment,
  • the type and length of the loan, and
  • whether or not you pay points at closing.

The down-payment relationship is fairly straightforward. When you put more money down, you are reducing the size of the lender’s investment and also their risk. With all other things being equal, a larger down payment will typically result in a better (lower) mortgage rate. On the other hand, borrowers who put less money down are typically charged more in interest.

The type of the loan, and the length of the term, can also influence how the lender determines your mortgage rate. Take a look at the table below. This snapshot was taken from the Freddie Mac website around the time this article was published. It shows the average rates assigned to four different types of loans. They are based on Freddie Mac’s weekly survey of the lending industry. Notice the differences in the “Average Rates” as you move across the top gray column.

Image: Snapshot of average mortgage rates, as of October 17, 2013

As you can see, lenders charge higher rates for the 30-year fixed-rate mortgage (FRM), when compared to the other products. Longer-term loans represent a higher risk for the lender. And you know what that means. The 5-year ARM loan, on the other hand, is a riskier product for the borrower but better for the lender — that’s because the interest rate can rise over time.

So there are borrower characteristics that determine the mortgage rate, such as credit scores and debt ratios. And there are loan-related characteristics that influence the rate, such as the length of the term.

Lenders also determine your mortgage rate based on the amount of points paid at closing — or the lack thereof. A “discount point” is a form of prepaid interest that can be used to secure a lower rate when taking out a home loan. One point equals one percent of the loan amount. Some borrowers choose to pay points at closing (an out-of-pocket expense), in exchange for a lower interest rate (long-term savings).

I’ve covered discount points in a previous article, if you’d like to learn more about them.