How Are Mortgage Rates Determined?
Are you currently renting? If so, you’ve probably heard homeowners try to tell you that owning a home is more beneficial than renting. Depending on what your financial and homeownership goals are, this may be the case. When you buy a home, you have two clear options: pay in full or obtain a mortgage. In most cases, your only choice will be the latter. As with any loan, obtaining a mortgage means that an interest rate is part of the equation.
Most homeowners are cautious when it comes to their interest rate. Essentially, your mortgage rate will determine the cost of borrowing money from your chosen mortgage lender. If you’ve followed mortgage rates in the past, you know that they fluctuate daily, similar to the stock market. What is behind that fluctuation? This article will discuss how mortgage rates are determined and what certain factors are dependent and independent of the borrower’s control.
Factors in Your Control
At an early stage in the home buying process, clients will make certain choices leading up to “the one” that can play a role in what interest rate they receive from their mortgage lender.
Property Type
Did you know that the property type you decide to buy may have a modest influence on the mortgage rate you receive? Purchasing land, a condo, town-home, or a house in a gated community is often referred to as a “Planned Unit Development” and is considered a more risky investment that can land you a higher rate. In contrast, owner-occupied, single-family homes are considered less risky investments. Although the rate difference between purchasing a condo or a house is not drastic, financing a single-family home may influence your mortgage rate.
Credit Score
Since your credit score dictates the behavior associated with your financial habits it is a compelling force toward your mortgage rate. Lenders may analyze your credit score to determine the likelihood of mortgage payment fulfillment and set your mortgage rate accordingly. Those with lower credit scores may receive a higher mortgage rate to protect the mortgage lender’s investment. Some common rate adjustment thresholds are 620, 680, 700, 720, 740, and 760. Luckily, there are ways to repair a low credit score and save you from receiving a higher rate.
Down Payment
The size of your down payment impacts your mortgage rate. If your financial situation allows you to put a down payment of 20 percent or more, you might qualify for a lower rate because the lender now has a solid portion of the mortgage already paid down. This is due to the lender’s risk being reduced. Keep in mind, mortgage insurance allows you to put down less than 20% and there may also be down payment assistance programs available to support your home loan goals.
Loan Amount and Loan Program
Loan programs such as FHA, VA, conventional, and jumbo all have different rates impacted by a number of factors. The loan amount on your mortgage coupled with the loan program you choose can influence your overall rate. Every county has different loan limits that decide baseline loan amounts. If your loan is outside of the conforming loan limits, you may need to seek a jumbo mortgage which might result in an elevated rate.
Loan Type
Your choice of a fixed-rate or adjustable-rate mortgage also plays into what your rate may be. Adjustable-rate mortgages are fixed for a period of time before adjusting to a much higher rate, so they may start with a lower rate than a fixed-rate mortgage. In some cases, an adjustable-rate mortgage with a 3-year fixed-rate feature may have a lower rate than a 5-year fixed-rate feature, which in turn may have a lower rate than a 7-year fixed-rate feature. This rate structure is similar to that of fixed-rate mortgages. A 15-year fixed-rate mortgage may have a lower rate than a 30-year fixed-rate mortgage since the term of the loan is shorter and the borrower is making larger payments.
Discount Points
Say the rate you received was out of your range; luckily, there may be an opportunity for you to purchase points toward the rate. A consultation with your mortgage lender will decide if this is an ideal route for you. This might look like paying a certain percentage upfront to lower your rate by 0.125% since this may be the best value. To take it further, you may pay extra and decrease your rate by 0.25% or even 0.375%. This concept is often referred to as buying “discount points” or “points”.
Factors Out of Your Control
Unfortunately, the fate of the mortgage rate is not entirely in the hands of the clients. Due to external influences playing a role in fluctuating mortgage rates, clients may find it beneficial to understand what those other factors may be.
Federal Reserve
The Federal Reserve is a central bank system that serves to keep the economy stable. When the economy is going too slow or too fast, the Fed takes counteracting measures to maintain a healthy balance in the economy. When the Fed sets the federal funds at a higher target range, they begin selling bonds and other securities to banks to push banks into raising the federal funds rate. This usually works as expected with banks raising their rates to restrict borrowing.
Both the discount rate and the prime rate closely follow the federal funds rate, directly affecting a rise in the federal funds rate. Since the prime rate is utilized as a benchmark for the mortgage rates that banks offer to their customers, a rise in the federal funds rate creates a ripple effect that eventually makes its way to mortgage markets and affects your mortgage rate.
Central Bank Policy
Since 2008, mortgage rates have been highly dependent on what the central banks implement as their economic policy.
Defined by Investopedia, a central bank is “a financial institution given privileged control over the production and distribution of money and credit for a nation or a group of nations. In modern economies, the central bank is usually responsible for the formulation of monetary policy and the regulation of member banks.“
Over the past decade or so, mortgage rates have been adjusting lower while global central banks have been working hard to stabilize the economy. Lower rates allow more people to obtain financing and loans at a lower cost which, in turn, helps the economy. As rates and the cost of borrowing increase, fewer people can afford to take out more loans or purchase new things.
Economy and Stocks
Simply put, the state of the economy is a critical indicator of mortgage rate trends, and is dependent on national and global central bank policy as referenced above. Generally speaking, mortgage rates tend to go up when the economy is robust and tend to go down when the economy slows and stalls.
Rates tend to follow inflation trends that have to do with how much inflation is present in the current economy.
According to the Federal Reserve, “Inflation is the increase in the prices of goods and services over time… inflation is a general increase in the overall price level of the goods and services in the economy. Federal Reserve policymakers evaluate changes in inflation by monitoring several different price indexes.”
If inflation is increasing, rates tend to increase as well.
Mortgage-Backed Securities, Bonds, and the Secondary Mortgage Market
The secondary market is where loans are often sold after they are closed with your lender. Upon completing a mortgage transaction, your lender may package your loan along with others with the same rate and term and sells that group of loans to investors or government-sponsored agencies (GSE), such as Freddie Mac and Fannie Mae. This exchange is referred to as a “Mortgage-Backed Security” (MBS). The secondary market exists to keep money flowing through the mortgage industry by allowing smaller banks to lend money to other parties instead of having all of their capital tied up in a small number of investments.
Mortgage-backed securities and bonds are considered low-risk investments because they have a fixed return built into them that stocks do not offer. Investors want their money to work for them at all times, so they alternate between bonds (low-risk) and stocks (high-risk) depending on the state of the economy. For example, individual investors may invest in a 30-year or 15-year mortgage security to collect the interest paid on the mortgage loans in that security. When the economy weakens, investors tend to flock to bonds and fixed income investments, raising the bond’s price and lowering the bond’s yield (also referred to as the bond’s rate).
Lenders price their mortgages against the mortgage program’s corresponding bond; for example, a 30-year conventional loan is priced against the Fannie Mae 30-year bond. When the bond yield of a loan program is lower, this not only tells lenders that they can sell the loan to the GSE in question for a lower price, it tells lenders that the economy is making lower rates more of a necessity for its clients.
Talk With Your Loan Officer
While many homeowners initially anticipate that their rates come down to lender decisions, in actuality, the result is a combination of many factors. Some factors in your control can sway your received mortgage rate, while others are volatile and ongoing, such as the economy and the secondary market. Focus on the items that you can control to ensure that you are receiving the most optimal rate possible when you are ready.
Although interest rates can make or break your home loan process, they should not be your only benchmark in determining the lender that you choose. Consider other qualities and features such as loan origination fees, company history, and even customer service. If this article piqued your interest for a more in-depth explanation of mortgage rates or for a side-by-side comparison of the rates today, give us a call today and we can assist you as needed.
Financing details are for educational purposes only. Rates, program terms, fees, and conditions referenced are subject to change without notice. Not all products are available in all states for all amounts. All mortgage applications are subject to underwriting guidelines and approval. This is not an offer of credit or a commitment to lend. Residential Wholesale Mortgage, Inc. dba RWM Home Loans is an equal housing lender licensed by the CA Department of Real Estate #01174642 and CA Department of Financial Protection and Innovation under the California Residential Mortgage Lending Act. NMLS# 79445
