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How to lower your interest rate
Shopping for a loan that meets your needs is only part of the interest rate equation.
Advertisements for home loans are packed with eye-catching interest rates that oftentimes seem to be too low to be true. And in fact, those rock-bottom rates aren't available to most borrowers.
Yet some people are able to borrow money at attractive rates. Here are some strategies that can help you accomplish that objective:
1. Strengthen your credit score
Lenders rely on your credit report and credit score to assess your willingness and ability to repay your debts. The credit report is a history of how you've handled debt over time, and the credit score is a numerical representation of the information in your credit report.
If your score is high, lenders will offer their most attractive interest rates to you. If your score is middling or worse, lenders will dig into your credit history and then decide what rates to offer to you.
Lenders may give special attention to whether you made any late mortgage payments in the past 12 to 24 months. If you did, the lender then will assess the number and duration of those "mortgage lates" along with other factors. Be prepared to explain why your payments were late and to produce supporting documentation for your explanation.
Be upfront about your credit history because problems that are discovered later can disqualify you from certain loan programs or interest rates or derail your loan application altogether. Positive factors, such as a lengthy credit history or stable employment, can offset negative factors to some extent.
2. Shop around for lower interest rate
Regardless of your credit score, you should shop around for the best rate that's available to you on the type of loan you want. Ask several lenders to give you a Good Faith Estimate, which you can use to compare the costs of each loan. If you're shopping for an adjustable-rate mortgage, compare loans that use the same index and shop for the lowest margin and rate caps.
3. Higher points mean lower interest rate
Another way to get a lower interest rate is to pay points, which are an upfront fee quoted as a percentage of the loan amount. (One point equals one percent of the principal.) An inverse relationship exists between points and the interest rate: Pay more points, the rate drops. Pay fewer or no points, the rate rises.
The decision of whether to pay points is essentially a math problem, though you might want to consider how long you intend to own the home and whether you have other immediate financial needs as well. To estimate how long it would take to recoup points, multiple your loan principal by the number of points, then divide the result by the monthly payment savings from having a lower rate. For more information, read about discount points.
4. Get a rate lock to stop floating
Interest rates change daily as conditions change in the financial markets. That means a rate offered to you one day might not be available another day. To escape this fluctuation of interest rates, request a rate lock. A lock, which typically lasts 30 or 60 days, can help you make sure you'll get a specific rate you've been offered. Some lenders charge a fee for a lock, and if there is a fee, it's likely to be higher for a longer lock period.
Is now the time to refinance your ARM?
If the interest rate on your ARM is due to adjust soon, you should consider whether it makes sense to get a new loan.
Like many home buyers, you may have chosen an adjustable-rate mortgage because the introductory interest rate kept your monthly mortgage payments affordable during your early years of homeownership. But every adjustable-rate mortgage resets sooner or later, and when yours adjusts, you might be facing a substantially higher monthly payment.
The possibility that your payment might climb even higher may prompt you to consider refinancing your adjustable-rate mortgage with a different loan product. The choice to refinance isn't easy, but there is no need to panic or overreact to a higher payment.
Factors to consider
The difference between the reset monthly payment on your existing mortgage and the amount you would pay on a new mortgage is the most obvious factor to consider, but shouldn't be the only factor you keep in mind. Other considerations might include the caps and adjustment periods on your current mortgage, the outlook for higher (or lower) interest rates, the cost to you in time and money to obtain a new mortgage, and how much longer you expect to own your home.
The caps and adjustment periods on an adjustable-rate mortgage can protect you against substantially higher payments even if interest rates continue to rise. It's difficult to predict interest rates, but you can educate yourself and pay attention to financial-market news, so you can make smarter decisions.
A new mortgage can cost thousands of dollars and take many hours to research, apply for and close. If you expect to sell your home within a few years, the benefits of a new mortgage might not justify the outlay of time and money. That's especially true if you itemize your income tax deductions since a higher mortgage payment could be partially offset by a bigger break on your taxes. (Consult a tax advisor about your situation.)
New mortgage may be advantageous
If you obtained an adjustable-rate mortgage within the past few years, your payments might not be lower on a new fixed-rate mortgage today because interest rates now are likely higher than they were when your mortgage was originated.
Moreover, if you refinanced into a new loan that wouldn't be paid off as quickly as your existing mortgage, you would have to make more payments into the future. For example, if you had made payments for five years on a 30-year ARM, you would have 25 years of payments left to make. But if you refinanced your ARM to avoid higher payments and you chose a 30-year term, you would be making payments for an additional five years. That means lower monthly payments might not be advantageous because you might need to make a lot more of them to pay off your new loan.
A new loan might offer other benefits, however. For instance, a fixed-rate mortgage would protect you against the possibility of even higher monthly payments in the future, an advantage that's especially important if you plan to own your home for a long time.
Adjustable rate can be advantageous as well
You also might want to refinance one type of adjustable-rate loan into another type of adjustable-rate loan that would reduce, but not eliminate your exposure to higher interest rates. A lender can help you figure out which products might accomplish this objective.
An adjustable-rate mortgage may offer a key benefit that's simply not a function of fixed-rate products: That is, your payments could be reset lower as well as higher as interest rates fluctuate over time. An adjustable rate is always riskier than a fixed rate, but if you can shoulder that risk, you may be rewarded with lower payments in the future.
Refinancing can protect you from rising interest rates
Concerned that rising interest rates will make your monthly ARM payments hard to handle? Consider mortgage refinancing.
You can't control interest rates. But you can protect yourself when rates are on the rise by refinancing your adjustable rate mortgage (ARM). Here are some options to consider:
Fixed-rate mortgage
Chances are, you originally chose an ARM because it offered a lower initial interest rate than a fixed-rate mortgage. However, if monthly payment increases have become more difficult than you bargained for, or you're concerned that further jumps will seriously strain your budget, you may want to consider refinancing to a fixed-rate mortgage. The rate you'll get may be somewhat higher than your current ARM rate, but you'll have peace of mind -- your monthly payment will be consistent for the entire term of the loan, and you can budget accordingly.
Hybrid ARM
Another option is a hybrid ARM. These mortgages have an initial period (usually between three and 10 years) during which the interest rate is fixed, after which it is adjusted annually. They carry lower rates than 30-year fixed-rate loans, yet they offer stability for the medium term. If you believe rates will rise for a while longer but then settle or begin to drop again, refinancing to a 3/1 or 5/1 ARM may be worth a look. (The first number indicates the length in years of the fixed-term; the second indicates the adjustment interval once the fixed-term period has expired.)
More stable index
There's something else to consider if you're thinking about how your ARM will be affected by rising interest rates. At each adjustment period, your interest rate moves up or down based on a particular index. Some indexes are more volatile than others, meaning that they are subject to bigger peaks and valleys. By switching to an ARM with a more stable index, you will be less vulnerable to interest-rate swings.
More favorable caps
Your ARM also has built-in "caps," or maximum amounts the rate or monthly payment can rise from one adjustment period to the next. By refinancing to an ARM with more favorable caps, you can limit your exposure to higher rates.
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Mortgage lock-ins
When you're looking for a mortgage, you should shop among lenders for the most favorable interest rate and the lowest points and other up-front charges.
Lock-ins are a way to ensure that at settlement, you get the terms you requested from your lender.
What is a lock-in?
A lock-in, also called a rate-lock or rate commitment, is a lender's promise to hold a certain interest rate and a certain number of points for you, usually for a specified period of time.
Depending upon the lender, you may be able to lock in your interest rate and points:
- when you file your application
- during processing of the loan
- when the loan is approved
- at a later date
| Pro |
Con |
| Lock-ins protect you against increases while your application is processed. |
A locked-in rate may prevent you from taking advantage of price decreases during this period. |
Will your lock-in be in writing?
It is wise to obtain written, rather than verbal, lock-in agreements to:
- Fully understand how your lender's lock-ins work.
- Have a tangible record of your arrangements with the lender in the event of a dispute.
Obtain a blank copy of a lender's lock-in form to read before you apply for a loan. If possible, show the lock-in form to a lawyer or real estate professional.
Will you be charged for a lock-in?
Lock-in fees may or may not be refundable if you do not close your loan. The amount of the fee and how it is charged will vary among lenders and may depend upon the length of the lock-in period.
How long are lock-ins valid?
Lock-ins of 30 to 60 days are common but lock-in time periods may range from seven to 120 days. Usually, the longer the period, the greater the fee. Before deciding on the length of your lock-in:
- Ask your lender to estimate (in writing, if possible) the time needed to process your loan.
- Factor in any delays that might affect settlement (construction issues, etc.).
- Ask for a lock-in with as few contingencies as possible.
What happens if the lock-in period expires?
If your lock-in period expires, you could lose the interest rate and the number of points you had locked in. In this situation, most lenders will offer you a loan based on the prevailing interest rate and points, which may now be higher due to market conditions.
This information is adapted from "A Consumer's Guide to Mortgage Lock-Ins" published by the Federal Reserve Board and the Office of Thrift Supervision.
Adjustable rate mortgage (ARM) indexes
When choosing an ARM, it's important to consider its index in order to help protect yourself from interest rate fluctuations.
When you take out an adjustable rate mortgage (ARM), you know that the interest rate will one day change. So it's important to know how that interest rate will be adjusted when the day arrives. This is done using an index, and understanding indexes can help you choose the mortgage that will cost the least in the long run.
What is an index?
An index is a published interest rate based on the returns of investments such as U.S. Treasury securities. The rates for these investments change in response to market conditions, so an index tends to track changes in U.S. or world interest rates.
How ARM interest rates are calculated
To calculate the interest rate on an ARM, a lender starts with a particular index rate and then adds a predetermined number of percentage points (called the margin) to get the final rate. Since the margin usually stays the same throughout the life of a loan, changes in the index rate dictate how your mortgage rate will change at each adjustment date (the specific date -- often every one, three or five years -- upon which your ARM rate is adjusted).
As an example, say your mortgage starts with the following:
Index = 4.5%
Margin = 2.5%
ARM rate = 7%
At your adjustment period, say the index has risen 1 point, to 5.5%:
Index = 5.5%
Margin = 2.5%
ARM rate = 8%
Different types of indexes
Lenders use several different types of indexes to set ARM rates and these index rates can differ significantly. Some indexes are relatively stable while others tend to be far more volatile. Often, ARMs based on more stable indexes carry a higher margin than those based on indexes that are more apt to react quickly to market conditions.
Generally, it's better to have a slow-moving index when interest rates are rising and a fast-moving index when they are falling. However, these index rates only become a factor on your adjustment date, and interest-rate trends are hard to predict.
The indexes most often used by lenders are:
- 12-Month Treasury Average (MTA): This index, also known as the 12-Month Moving Average Treasury index (MAT), is based on a moving average of the monthly yields on U.S. Treasury securities. It's adjusted once a month and moves slowly, lagging the other indexes.
- 11th District Cost of Funds index (COFI): This widely used index is calculated monthly based on the weighted average of interest rates paid on savings and checking accounts by institutions in the 11th Federal Home Loan Bank District (consisting of banks based in Arizona, California and Nevada). Its rate also tends to change slowly.
- Constant Maturity Treasury indexes (CMT): These indexes follow the average weekly or monthly yields on U.S. Treasury bills. They are more attuned to events in the economy and can change rapidly. The one-year CMT is widely used for mortgages with annual rate adjustments.
- London Interbank Offered Rate indexes (LIBOR): These are based on the average interest rates London banks borrow funds from each other. They are more volatile than the COFI or MTA indexes. However, LIBOR-based mortgages tend to have low initial rates. They also tend to have lifetime and periodic interest rate caps to protect borrowers from spikes in the index rate.
Other indexes used by lenders include the Treasury Bill index (T-Bill), Certificate of Deposit Index (CODI), Cost of Savings Index (COSI), and Bank Prime Loan or Prime Rate index. Knowing which index a mortgage is based on can give you a better idea of your future risk from interest rate fluctuations.
 
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