Why this article is important: How do mortgage loan originators (MLOs) determine the interest rate to offer mortgage applicants? This article examines the factors that go into the decision.
Situations affect the interest rate offered
Consider a homebuyer seeking to purchase a single family residence (SFR). They have a 20% down payment saved and a relatively strong credit score of 760.
Following the advice of their real estate agent, they apply to three different MLOs — not because they think they will be denied credit, but because they are after the best interest rate and mortgage terms. They receive mortgage offers at three different interest rates.
What accounts for the MLOs’ varying offers?
Each MLO and their lender uses its own process to determine the mortgage rate and terms they offer an applicant. This qualification system, called risk-based pricing, sorts applicants into tiers. The most qualified applicants are offered the best rates and terms.
Notably, this risk-of-loss analysis used to evaluate financial and credit information removes any MLO conduct which may discriminate against an applicant based on their status, including:
- race, color, religion, national origin, or ancestry;
- sex, gender, gender identity, gender expression, or sexual orientation;
- marital status or familial status;
- source of income; or
- disability or genetic information. [Calif. Civil Code §§51 et. seq.; Calif. Government Code §12955; DRE Reg. §2780 and §2781]
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The necessity of a risk-based pricing model is its application of the same metrics to every applicant as the best way to eliminate potential bias by MLOs.
The interest rate set by the secondary mortgage market as the cost of funds available to the MLO is called the par rate. It is the base rate to which the MLO applies the risk-based pricing analysis to set the mortgage rate offered to the borrower.
Par rate for funds the MLO lends
The par rate is the MLO’s neutral base interest rate, primarily swayed by the secondary mortgage bond market, to which the MLO adds premiums and fees, or subtracts for any discounts. However, the par rate is not the final number for any homebuyer borrower; it is the MLO’s starting point.
Mortgage par rates shift in the mortgage-backed bond (MBB) market on a daily basis. The par rate consists of:
- a base or “real” rate of return, say, at the 10-year Treasury Note rate less the rate of anticipated long-term inflation (CPI);
- the rate of inflation; and
- a risk-of-default premium rate.
Historically, the default risk premium spread between the 10-yr T-Note rate and the 30-yr FRM rate hovers around 1.5% (the spread is far greater for cap rates evaluating income property).
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On top of daily variations and long-term trends in the 10-year T-note interest rate market, the par rate is adjusted by the MLO to set the offered mortgage interest rate based on the borrower’s:
- credit score;
- income;
- debt-to-income (front-end and back-end DTI) ratios;
- employment history; and
- chosen mortgage type.
Loan to value (LTV) ratios higher than 80%, experienced by a down payment of less than 20%, require mortgage insurance. Mortgages may be guaranteed or insured by the U.S. Department of Veterans Affairs or the Federal Housing Administration (FHA). These high LTV mortgages tend to have lower par rates than conventional mortgages with LTV ratios of 80% or more.
However, the lower par rates for government-backed mortgages are fully canceled out by the mandatory addition of:
- mortgage insurance premiums (MIP) to monthly payments for FHA-insured mortgages; and
- the upfront funding fee bundled into VA-guaranteed mortgages.
These variables based on a down payment less than 20% are added to the par rate which give borrowers wiggle room to improve the mortgage rate an MLO offers. Further, other more fluid variables determine a borrower’s final mortgage rate offered by an MLO, such as:
- the borrower’s down payment, with a higher down payment resulting in a lower interest rate;
- mortgage insurance, when the borrower’s down payment is less than 20% of the purchase price;
- mortgage term, as a term shorter than 30 years results in a lower base par rate;
- property use, with a primary residence receiving lower rates than properties for other uses; and
- any discount points paid to “buy down” the mortgage rate offered by the MLO.
Of course, each MLO seeks different profit margins and have varying operating costs. Thus, the borrower’s chosen MLO also affects the borrower’s mortgage rate.
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An applicant’s tier based on credit scores
Consider three different mortgage applicants with varying levels of creditworthiness. All have the same income and DTI ratios.
The first applicant has a credit score of 760+ and a 20% down payment. Based on the MLO’s risk-based pricing model, they are a Top-Tier applicant and receive the best rate and terms the MLO offers.
The second applicant has a credit score in the mid-range, 680-to-760, and a down payment of 10% which require payment of mortgage insurance premium (MIP) by the buyer. Based on the MLO’s model, they are a Mid-Tier applicant.
The third applicant has a low credit score of 580-680, and a 10% down payment which requires the buyer to pay a monthly MIP. Based on the MLO’s risk-based pricing model, this applicant is a Low-Tier applicant, eligible for mortgage approval at their least competitive interest rate and terms.
In this example, the interest rate offered each applicant is:
- for the Top-Tier applicant, 6.5%;
- for the Mid-Tier applicant, 6.85%; and
- for the Low-Tier applicant, 7.6%.
Based on the same income for each applicant, the amount of mortgage funding mid- and low-tier applicants can borrow is reduced, and thus the price range for their housing.
Further, since all tiers have the same DTI ratio needed to qualify, the buyers with lower credit scores (and thus higher interest rates) are restricted to borrowing less mortgage principal. In other words, the lower tier applicants are only able to take out a maximum mortgage principal of:
- $482,500 for the mid-tier applicant; and
- $447,000 for the bottom-tier applicant.
On top of the additional interest payment is the mortgage insurance premium payment for applicants with less than a 20% down payment. The insurance premium is around 0.66% of the mortgage balance, and is added to the monthly payment due the lender. Thus, the amount of mortgage funds available to borrow is further reduced due to the same DTI ratio applied to all mortgages.
Continuing this example, examine how the creditworthiness of applicants shifts the mortgage principal available, assuming each applicant has the same income and is applying for a 30-year FRM.
| Down payment | Credit score | Interest rate | Monthly payment at 30% of income | Mortgage principal available | |
| Top tier applicant | 20% | 760+ | 6.5% | $3,160 | $500,000 |
| Mid tier applicant | 10% | 680 – 760 | 6.85% | $3,160 | $482,500 |
| Low tier applicant | 10% | 580 – 680 | 7.6% | $3,160 | $447,000 |
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APR provides a cost-of-borrowing picture
The annual percentage rate (APR) accounts for both the mortgage interest rate and all additional mortgage fees charged as viewed over the term of the mortgage, say, 30 years. This provides a more accurate representation of how much the buyer actually pays for the mortgage funds available for a home purchase as compared to the interest rate alone.
When an applicant has a down payment of less than 20%, mortgage insurance is required to cover the lender’s greater risk of loss. This comes in two forms:
- mortgage insurance premium (MIP) for Federal Housing Administration (FHA)-insured mortgages; and
- private mortgage insurance (PMI) for conventional mortgages.
For example, in 2025, the average MIP for a 30-year FRM was 0.55%. The average PMI for a 30-year FRM was 0.68%.
For example, the Mid-Tier applicant borrows a conventional mortgage of $482,500 for a 30-year fixed rate term. Their interest rate is 6.85%. Since their down payment is less than 20%, they are required to pay for mortgage insurance. Therefore, their total interest rate is 7.53% and their total monthly mortgage payment to the lender is $3,384.
However, the MLO informs the applicant of the option to purchase mortgage discount points to reduce — buy down — the mortgage interest rate and the mortgage payment.
Typically, MLOs offer mortgage points at the price of 1% of the mortgage amount per one-quarter of a percentage point reduction in the offered mortgage interest rate. For this mortgage, when the buyer wants to reduce their interest rate by one-quarter point, from 7.53% to 7.28%, they will pay $4,825 for the mortgage point.
Their mortgage origination fees charged are:
- mortgage insurance premiums;
- loan origination and underwriting fees; and
- the cost of the discount point paid to reduce the interest rate.
Fees to third-party service providers, such as appraisal, home inspector and title insurance fees are not included in the APR calculation. Any fees paid upfront — at closing — are also not included.
Continuing our example, the Mid-Tier applicant taking out a $482,500 mortgage at 7.28% pays mortgage origination fees equal to $10,800 (including the fees charged to reduce their mortgage rate).
Thus, their APR is 7.514%. This calculation is provided with the Loan Estimate form prepared and delivered to every mortgage applicant within three days of submitting a completed application. The APR provides a truer representation of the cost of the amount of money actually borrowed, one which the applicant can compare with other MLO offers.
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