Mortgage Dos and Don’ts

Mortgage rates hit all-time lows repeatedly in 2020 and through early 2021 amid the impact of the COVID-19 pandemic. Rates have started to drift higher over the last few weeks and may continue to rise modestly through the year. If you’re thinking of getting a mortgage or refinancing the one you already have, there are a number of factors to consider.

What Influences Mortgage Rates?

Mortgage rates are influenced by a number of different factors: the economic environment, inflation, and the Federal Reserve.

The Federal Reserve’s Fed Funds Rate, the key overnight bank lending rate that influences all kinds of other interest rates, has stood at a target range of 0.0% to 0.25% since March 15, 2020, at the start of the COVID-19 pandemic.  

As the economy recovers in 2021, the Federal Reserve may start to raise interest rates, which can have an overall impact on your mortgage rate. When and how depends on what kind of mortgage you have. Long-term fixed-rate mortgages are tied to the yields of long-term U.S. Treasury notes. When these yields rise, so do interest rates. Adjustable-rate mortgages (ARMs) and home equity lines of credit (HELOCs) are tied to the prime lending rate. When the Fed raises its rate, banks hike their prime rate, therefore increasing your mortgage rate as well. 

The average 30-year fixed-rate mortgage rose last week to 3.17% last week with an average 0.7 point, according to Freddie Mac. (Points are fees a lender must pay in addition to the interest rate, equal to 1% of the loan total). While rates remain near the all-time historic lows of 2.65% hit in January 2021, they, nonetheless have been on the rise for the last six weeks. With more Americans getting vaccinated, more businesses reopening, and more stimulus money helping to boost the economy, rates are expected to inch higher over the coming months.

As the economy continues to strengthen and affect mortgage rates, we thought it made sense to look at a few dos and don’ts for anyone planning on getting a new mortgage.

Check Your Credit Report

Lenders review your credit report to determine if you qualify for a loan and at what rate. By law, you are entitled to one free credit report every year from each of the “big three” credit rating agencies — Equifax, Experian, and TransUnion. Take a close look at your credit report to make sure it’s accurate. If there are any mistakes, you should take immediate steps to fix them. Watch out for suspicious items, identity theft, data from a former spouse that no longer belongs to you, out-of-date information, and incorrect notations for closed accounts. Follow up with the lender or creditor who reported the item and make sure you report inconsistencies directly to the three agencies. 

Improve Your Credit Score

Generally, a high credit score means you’ll qualify for a better mortgage, so it pays to keep it as high as possible. The most common is the FICO score, which many financial institutions provide for free to their customers each month. You can also purchase your FICO score from one of the three credit rating agencies.

To improve your credit score, pay down debt, set up payment reminders to pay bills on time, keep credit card and revolving credit balances low, and reduce the amount of debt owed. One of the best ways to do that is to stop using (or restrict usage of) your credit cards. 

Lower Your Debt-to-Income Ratio

Lenders look at your debt-to-income ratio — or your debt repayment compared to your overall income — to measure your ability to manage your monthly payments. They also use it to determine how much house you can afford. Lenders like to see debt-to-income ratios lower than 36%, with no more than 28% of that debt going toward mortgage payments, or the front-end ratio. The stronger these ratios, the better your mortgage rate.

There are two ways to lower your debt-to-income ratio so you get a better mortgage rate:

• Reduce your monthly recurring debt: Stop spending money on anything except the most urgent purchases.
• Increase your gross monthly income: Get a second job or work extra hours to boost your income potential.

While these options are possible, keep in mind that neither of these is always easy to accomplish. 

Consider the Amount of the Mortgage

Remember, qualifying for a certain amount doesn’t mean you have to spend that much on a home.

A conservative approach is to spend no more than 30% of your take-home pay on housing costs, which includes your mortgage, property taxes, homeowner’s insurance, and homeowner’s association dues. Don’t forget to add in maintenance costs if you really want to make sure you’re looking in the right price range. When shopping for homes, decide what’s more important: having a more expensive home or having a little extra wiggle room in your budget each month. Bear in mind, being a homeowner with a mortgage is a 30-year commitment. 

Don’t Count on Refinancing to Lower Your Interest Rate

Mortgage rates have started to edge up from historic lows, and they may keep rising off the historic lows, so it might not be the right time to refinance. But you may be able to save money by shortening your loan term.

For example, moving from a 30-year fixed-rate mortgage to a 15-year loan with a better rate, or through a cash-out refinancing, in which your new mortgage amount is greater than the existing one. This allows you to tap into your home equity to pay down other debts. Even though your monthly payment will rise, you could end up saving money by paying off higher-interest debt, such as your car loan, student loans, and/or credit cards.

Before doing any refinancing, you should crunch the numbers to make sure you aren’t adding to your financial stress.

The Bottom Line

Even a small change in interest rates can make a big difference in monthly payments, the amount of interest paid over the course of the loan, and the size of the loan (and house) for which you’ll qualify. If you have a $200,000 30-year fixed-rate mortgage at 4%, for example, your monthly payment would be $954.83, and you’d pay $143,739.01 in total interest. Bump the rate up by 0.5% (for a total of 4.5%), and you’d be looking at a monthly payment of $1,013.37, and your total interest paid would be $164,813.42 — that’s about $2 more per day for 30 years.

Given the above, it is always a good idea to work on improving your credit score, credit history, and debt-to-income ratio, so you can qualify for the best rate available. And, of course, don’t take on more house than you can comfortably afford.