It’s always good to know how mortgage rates are determined. Because for sure, it will impact not just the decision to buy a home, but to also buy the biggest investment of a lifetime.
There are 6 factors that have the largest impact on where the rates for home loans end up. Some of them can be controlled, some of them are probably out of your hands.
1. The Federal Reserve
Everyone hears about the Feds all the time. During the 8 meetings they have in a year, Fed governors decide where the federal funds rate should rest. (It is the rate at which commercial banks borrow and lend their excess reserves).
The Fed rate and mortgage rates nearly always move in the same direction. By the time of the Fed meeting, mortgage rates often reflect the expected rate change.
2. Economics
Stability of the economy plays a vital role in mortgage rates. If there’s instability in the economy like financial crises or recessions – lenders will view lending as a riskier affair without a doubt. It will also increase interest rates accordingly.
At a converse point of view, economic growth can cause lenders to lower rates. This will push for more borrowing, and simultaneously stimulate the economy.
What you can do is keep yourself in the know about the economy. You can also find a mortgage advisor to help you.
Quick note about why inflation is important for mortgage rates:
As of October 2024, the inflation rate in the U.S. rose by 2.6% on an annual basis. Why is this important? When inflation expectation increases, lenders will tend to raise rates in order to offset potential loss in future value. This could cause an uptick in mortgage rates. Inflation is an important point to consider while you’re looking to buy a house.
Quick note about labor markets and mortgages:
A week or a strong labor market impacts mortgage rates. If jobs in the market increase, it will lead to increased spending which could increase inflation and mortgage rates. If the job market slows down, it is usually beneficial for homebuyers because mortgage rates will be down.
Quick note about the 10-year yield:
A 10-year yield is important to home buyers because of its strong relationship with mortgages. The yield functions as a benchmark for corporate bonds, loans and mortgages.Mortgage rates tend to increase when the 10-year yield rises. This is because they compete with the same investors. So now you’ll be able to put two and two together knowing that everything you spend on, including buying a home, will be expensive.
3. Mortgage-Backed Securities
Mortgage rates and mortgage-backed securities share an inverse relationship. MBS prices go down when mortgage rates go up. It’s the same for the opposite as well. This can also mean that existing MBS(s) lose their value when rates increase because investors usually earn higher profits from securities that are newly issued.
Mortgage-backed securities (MBS) come with a rather big risk when interest rates drop – prepayment. Why is this important? While prepayments take place, the principal amount reduces rather quickly than expected. This means that overall returns are lower than normal.
Homeowners might have to refinance their mortgages if interest rates fall. MBS investors will view returns falling at the time of lower interest rates when alternative fixed-income securities are scarce.
Quick note: MBS are investment products that comprise a group of mortgage loans.
4. Types of Loans and Term
Finally! This is a factor that you can definitely control.
Conforming loans come with lower interest rates than non-conforming loans. Conforming loans also have lower downpayment requirements.This is because lenders can sell conforming loans to Freddie Mac or Fannie Mae (it means they’re willing to get less interest for the security that’s being getting rid off).
The term (or length) of the housing loan also impacts the rate you will pay. Those procuring 15-year mortgages will receive lower rates than those signing up for 30-year mortgages, which are the most popular ones in the country. Mortgage lenders are happy they will get their interest payments twice as fast on 15-year mortgages, so they are willing to knock down the rate for that advantage. Also, if you believe rates will move higher during the term of your mortgage, make sure to get one with a fixed rate. If you think it will decline in the future, go for an adjustable-rate mortgage.
Lastly, once you choose a loan that fits your needs, it may be smart to make as large of a down payment as you can – that will knock some points off your rate.
Quick note: Conforming loans are the most common type of loan available.
5. Credit Score
Before you apply for a mortgage loan, you need to know your credit score. The higher it is, the lower the interest you will pay on your loan. That’s because a high credit score shows lenders that you can be trusted to make payments on time.
If your credit score is below 740 (the level at which credit is considered excellent), make sure to pay down high-balance credit cards. Also, scour your credit report for any errors that may be hampering your score. After all, over 20 years, someone with a 680-699 score could end up paying about $20,000 more in interest on a $244,000 mortgage than a person with a higher score.
Quick note: If the mortgage underwriter has questions about red flags such as a gap in employment, you can always send a letter of explanation for credit inquiries.
6. Loan-to-Value Ratio
Though you may never have heard of this term before, it’s an important one in determining your interest rate. In simple terms, the loan-to-value ratio assesses the lending risk that financial institutions and other lenders are exposed to.
How are they calculated? Let’s say you want to purchase an $800,000 house, and you can afford to offer an $80,000 down payment. The $720,000 loan compared to the $800,000 value of the house means the ratio is 90 percent – a high number. A ratio at that level can hurt the interest rate you will receive. Why? As the percentage increases, the potential loss the lender will face if the borrower fails to repay the loan also rises, creating more risk.
So, are you all set with the understanding of mortgage rates?
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