Why Banks and Lenders Offer Different Mortgage Rates to Borrowers

The five most important points covered in this article:

• Banks and lenders offer different mortgage rates for different borrowers.
• Risk-based pricing has a lot to do with these differences.
• The type of loan you use can also influence the mortgage rate.
• You can use the ‘Loan Estimate’ form to compare costs among lenders.
• Shopping around could save you thousands of dollars on a home loan.

When shopping for a home loan, it’s always wise to compare offers from several different lenders. Surprisingly, however, a lot of borrowers choose the first offer they receive.

Past surveys have shown that more than 50% of borrowers did not compare rates. And that’s a costly mistake in the long run. Read on to find out why…

Why Lenders Offer Different Mortgage Rates

Let’s start with the most important concept you need to know.

Different banks and mortgage lenders might offer different mortgage rates — even to the same borrower. Knowing this, you can see the importance of shopping around and gathering multiple quotes.

There are several reasons for these rate differences, and risk has a lot to do with it.

Mortgage pricing (i.e., the fees and interest rates charged for a home loan) can vary from one lender to the next. These variations are largely driven by risk, as explained below.

Other factors can account for these differences. For instance, a borrower’s credit score and the size of the down payment could result in a lower or higher mortgage rate.

The type of loan being used can also make a difference, when it comes to interest.

The Concept of Risk-Based Pricing

Within the mortgage and banking world, there’s a concept known as “risk-based pricing.” As a borrower, you need to understand this practice, because it directly affects your interest rate and other loan-related costs.

According to the Consumer Financial Protection Bureau (CFPB):

“Risk-based pricing occurs when lenders offer different consumers different interest rates or other loan terms, based on the estimated risk that the consumers will fail to pay back their loans.”

Source: What is risk-based pricing? (CFPB.gov)

Mortgage lenders tend to charge higher interest rates for “riskier” borrowers, while offering lower rates to “safer” borrowers who are deemed to be a lower risk.

This is the main reason why different borrowers might receive different rates, even when using the same lender with the same exact loan size.

Lenders also have different procedures for measuring or assessing risk, along with different appetites for risk. No two mortgage companies handle it the exact same way. It can vary from one company to the next — and thus the pricing varies as well.

So, How Do Mortgage Lenders Measure Risk?

Lenders often use the borrower’s past credit history as an indicator of risk.

Credit scores essentially rate borrowers based on their previous borrowing history (credit cards, car loans, etc.). A borrower who makes all payments on time will have a higher score. A borrower with a pattern of missed payments or delinquencies will have a lower score.

Statistically speaking, a person with a lower credit score is more likely to default on a mortgage loan. So they are seen as a bigger risk, and charged a higher mortgage rate as a result.

Mortgage lenders use other factors to measure risk, as well. They might consider the size of the down payment, the borrower’s employment and income history, the amount of total debt they have, and more.

As mentioned, lenders have different methods for assessing risk and pricing loans:

• One company might look at your financial situation and view you as an extremely low-risk borrower, with a very low probability of default.
• Another company might see that you have a great credit score, but have an issue with the amount of debt you carry in relation to your income.
• A third lender might put more emphasis on down payments, reserving their best mortgage rates for borrowers who put down 20%.
• And so on…

So, risk-based pricing is one reason why lenders offer different mortgage rates to different borrowers. The type of home loan being used also plays a role. So let’s explore that next…

The Type of Mortgage Also Makes a Difference

The type of loan you use can partly determine the interest rate you receive.

For instance, let’s consider the difference between the 15-year fixed-rate mortgage and its longer-term counterpart, the 30-year fixed.

Generally speaking, banks and lenders tend to charge more for home loans with a longer repayment period. In contrast, shorter term mortgages tend to have lower interest rates.

If you look at the weekly mortgage rate survey conducted by Freddie Mac, you’ll notice that the average rate for a 30-year fixed loan usually tracks higher than the average for a 15-year mortgage. And the 5-year adjustable-rate mortgage (ARM), usually offers the lowest rates — at least initially.

Mortgage rates can also vary based on the particular loan program you’re using.

There are several broad categories of home loans, including conventional, FHA and VA. The amount of interest charged can vary, sometimes significantly, depending on the type of mortgage being used.

Using the ‘Loan Estimate’ to Compare Costs

At this point, you might feel overwhelmed by the complexity and intricacies of mortgage pricing. If different banks and lenders offer different rates, how can you compare one offer to another?

After all, we haven’t even covered the other fees that mortgage lenders can charge, such as origination and underwriting fees.

Fortunately, there are two items that can help you compare offers more efficiently:

• Loan Estimate — Mortgage lenders are required to provide borrowers with a Loan Estimate form shortly after they apply for a loan. This document, designed by federal financial regulators, gives you all sorts of information about your loan. Among other things, it shows the total costs associated with the loan (not just the rate). This makes it easier to compare one mortgage offer to another.
• APR — The annual percentage rate, or APR, represents the total costs of the loan. It includes the mortgage interest rate, but also other charges and fees such as buyer closing costs, mortgage insurance, origination fees and more. You can’t just compare rates. You have to look at the full cost of borrowing, and that’s what the APR shows you.

Page 3 of the “Loan Estimate” document actually shows you the APR, along with some other cost-related information. So it’s a very useful tool when it comes to comparison shopping.

Borrowers can obtain Loan Estimates from several different lenders, and then choose the best one based on the APR and other factors.

The image above shows the applicable part of the Loan Estimate form, where it mentions the APR.

As you can see, it also shows the total amount you’ll have paid over the first five years of the term, factoring in the mortgage rate and all other loan costs. That’s good information to have up front.

Shopping for the Best Rate Can Save You $$$

You might wonder why we place so much emphasis on “shopping around” and gathering multiple offers. After all, that kind of strategy takes time and effort.

Wouldn’t it be easier to choose the first offer, instead of trying to shave a few basis points off the interest rate?

Yes, it would be easier. But the easy path might end up costing you more over the long run.

Even saving a fraction of a percent on a mortgage rate could save you thousands of dollars over the life of the loan. And even if you only stay in the home for a few years before selling, it can still make a big difference.

The infographic below shows the difference in costs associated with a $200,000 home loan with slightly different interest rates. Note that the amount being borrowed is the same for all three scenarios. The difference is the rate that’s applied to the loan.

As you can see, even a seemingly small difference in the mortgage rate can make a big difference — in the short term and the long term.

Summary of Key Points and Pricing Factors

Let’s wrap up by looking at some of the factors that can affect mortgage pricing, for better or worse.

Factors that might help you secure a lower rate:

• High credit score: Borrowers with strong credit profiles get better rates.
• Large down payment: More equity lowers the lender’s risk.
• Loan type: Government-backed loans (FHA, VA) give lenders extra protection.
• Low debt-to-income ratio: Shows you have a good ability to repay the loan.
• Shorter loan term: 15-year mortgages often have lower rates than 30-year loans.
• Lower loan-to-value ratio: A lower LTV ratio reduces risk for the lender.
• Stable income: Reliable earnings increase the likelihood of repayment.
• Discount points or buy-downs: Paying extra upfront can lower the interest rate.

Factors that might lead to a higher mortgage rate:

• Low credit score: Lenders tend to charge more for higher-risk borrowers.
• Small down payment: Less equity increases the lender’s risk.
• High debt-to-income ratio: Lenders may see you as less able to repay.
• Longer loan term: 30-year mortgages may have higher rates than shorter-term loans.
• Loan amount: Very large loan amounts can lead to higher rates due to extra risk.
• Loan-to-value ratio (LTV): A higher LTV ratio also increases the risk level.
• Unstable or low income: This can raise concerns about repayment ability.

We hope this article has given you a better understanding of why banks and lenders offer different rates to loan applicants, and how you can shop smartly for the best deal.