How Credit Scores Impact Interest Rates
Your interest rate is directly impacted by your credit score and the equity in your home.
While there are other factors that can influence your interest rate, including property type (condo), or loan purpose (investment), that can greatly impact your costs, the combination of your credit score and your equity is by far the biggest factor.
Conventional loan programs offer competitive rates, reduced mortgage insurance, and low down payment, as low as 3% down, or 97% Loan to Value (LTV).
Once you discover that your credit score and equity is affecting your interest rate, the next question is how much will it cost you. The answer lies in Fannie Mae’s loan level price adjustment.
LLPAs are fees required by Fannie Mae or Freddie Mac. No matter which lender you use, these fees will apply to you, it’s comes down from the top!
Sometimes you have the ability to take action to increase your credit score, but coming up with a higher down payment is a lot harder to do.
Understanding how Loan Level Price Adjustments affect your costs, and possibly your rate, could save you tens of thousands of dollars over the long term.
Long Term Cost of Taking a Higher Interest Rate
If you have the assistance, assets, or gift funds to help pay closing costs, you might consider at least comparing the two options. The math will ultimately tell you which is the best financial path for you and your family.
The longer you plan to stay in the home, and in the same loan, the more you should consider paying closing costs upfront, and not include it in the interest rate.
As soon as you absorb the cost as interest rate, you influence the long term cost of that decision the longer you stay in that loan.
Here’s an example: If you are fortunate enough to buy, or refinance recently, you have a very, very low interest rate.
You are unlikely to see this interest rate for long, and you are unlikely to see this interest rate again. You might want to keep this loan for as long as you possibly can.
This is what is what the decision would look like if you thought you would like to keep your current interest rate for a long time.
- Original purchase price $320,000 w/ 5% down
- Original loan amount $304,000
- LLPA Costs (95% LTV 620-639 FICO): 3.25% = $9,880.00
- Below, you will see a typical day’s interest rates, including the cost of that interest rate.
If the number is in parenthesis, it is a rebate generated for you, to cover closing costs. In the above example, we have 3.25% in closing costs that we are trying to pay for.
Interest rate pricing changes every single day, sometimes several times a day. This is a typical example of what a common rate spread would look like to cover 3.25% in LLPAs.
Under this imaginary example, if I come up with just under $10,000, my interest rate could be as low as 3.99%.
Or, if I don’t have the money (more on that in a minute), I could take a higher interest rate of 4.75%, which would actually give you a small credit to be used for other closing costs as well.
Making Sense of the Math
The question you want to consider is, how long am I going to be in this loan? Is 4.75% a temporary loan that gets you into the home, just waiting for an opportunity to refinance to get a better rate?
Or, is 3.99% the best rate you’ll ever see, and you want to preserve it, and protect it for as long as you can?
Let’s look at the math for the example we’ve been following above. We already know that your Loan Level Price Adjustments add up to 3.25%, or $9,880, or .875% added to your interest rate.
Principle and Interest Payment Comparison
At a 3.99% interest rate, a hypothetical principal and interest payment could be: $1,449
This scenario means that instead of a 5% down payment, you’re looking more along the lines of needing 12%, including closing costs and fees. Compare this to rolling the LLPA into the interest rate.
At a 4.75% interest rate, under the same hypothetical assumptions as before, the PITI payment is $1,586
That’s a difference of $137.00 a month, or $1,644 a year.
This is where you have to think ahead. Doing a recuperation analysis, you would pay for the cost of paying the LLPAs as an upfront closing cost in 6 years.
- LLPA Cost: $9,880
- Divided by Payment Difference / $1,644/yr
- Equals “Break Even” = 6.00973 years
That means, that in 12 years, you would have saved almost $10,000, which, if you applied toward the principal balance of your loan, would far more than outweigh your original investment.
If you would have invested that $9,880 upfront, your return in 20 years would would have been $20,016 of interest payment savings. That’s $13,3136 saved!
It’s a long term “no brainer”, however, there’s a short term reality. How do you come up with an extra $9,880? I’m glad you asked.
3 Ways to Pay LLPAs
You can pay for Loan Level Price Adjustments by choosing the interest rate you want to pay, and payment the “cost” to get that interest rate. Using the above example, there are many ways to “get there”.
- Seller Concessions – It is not uncommon to ask the seller to pay for part of the buyer’s closing costs. The buyer in this scenario typically makes an aggressive offer at, or most likely above asking price, to make the seller’s cooperation a win/win situation for everyone involved.
- Gift Funds – If you have a parent or relative that wants to help you purchase a home, use the money to buy down your interest rate to help you save money every month.
- Interest Rate – When all else fails, you always have the option to take a higher interest rate, and get into the home, and start earning equity sooner, than later.
Ask an Expert
This is one of those scenarios where working with a mortgage professional will save you thousands of dollars. Most experienced loan officers can also help you increase your credit scores to help bring down the cost of financing your next home loan.
If you have any questions about your specific situation, feel free to ask a question or leave a comment below.