Home loan interest rates: risk versus reward

When determining an interest rate, a mortgage company must consider different types of risk. One type of risk is the likelihood that a particular borrower will pay back the loan in a timely manner. This is where a good credit history can be important; if you credit is less than perfect, you may get a higher interest rate or have to pay more closing costs.  Another important factor is debt to income ratio. A borrower with a high level of debt is seen as statistically more likely to default on loan payments. The added risk for this type of situation means the lending institution will need to charge a higher interest rate.

Another type of risk is the anticipated future market interest rate fluctuations. When making long term loans, a lending institution must try to anticipate what might happen with the market interest rate over the lifetime of a loan. The longer the loan, the greater the uncertainty about what may happen to rates over the period of the loan. One way to secure a lower interest rate is to choose a shorter term loan, such as a 15 or 20 year payback period. Mortgage companies can generally give a lower interest rate for these loans, because there is a shorter period of time for market interest rates to fluctuate.

Home purchases made with little or no down payment are also seen as riskier by lending institutions. If a borrower were to default on a loan where there is no equity, then the bank is more likely to lose money through the foreclosure process. This added risk corresponds to higher interest rates for loans with a low down payment. So the best rates can be obtained with a minimum 20% down.