If you’ve never bought a home before, or even if you have, the most mysterious piece of the mortgage loan process is understanding current mortgage interest rates. How are mortgage rates determined? Why do mortgage rates fluctuate? And why do they differ from one lender to another?
The Prime Rate
Current mortgage interest rates are determined by a number of different factors that reflect the state of the U.S. economy. In simplest terms, a strong economy — as described by the Federal Reserve Bank — has a low unemployment rate (ideally 5% or less), an inflation rate of 2%, and a strong Gross Domestic Product (GDP), which is a quarterly report that measures the total market value of goods and services.
There are roughly 50 or more measures of economic performance, which the Fed reports on every other month. Often referred to as leading economic indicators, they include:
- The consumer confidence index
- Labor market conditions
- Wage and price index
- Industrial production
- Oil prices
- Stock market indices
- and the list goes on…
Based on this detailed analysis, the Fed sets the Federal Reserve Funds Rates, also known as the Discount or Prime Rate, which is the interest rate banks charge one another to borrow money. This is the the starting point for the interest rate that a lender will offer you.
The General Interest Rate Market
Mortgage lenders are in business to make a profit. Most lenders sell their mortgages to what is called the secondary market. These loans are bundled or “securitized” with similar loans into what the industry calls Mortgage Backed Securities (MBS), and sold as bonds to investors. The price of these bonds is determined by market conditions, which in turn cause fluctuations in the interest rates offered by lenders. Because mortgage bond prices are determined relative to market benchmarks — most commonly the 10-year treasury bond which is backed by the U.S. government — they are deemed to be essentially “risk free.”
Here’s where you impact the mortgage interest rate.
Credit score – When a lender is determining the potential risk of lending you money for your home purchase, they take a number of factors into consideration. The factor with the most impact on your rate is your credit score. The better your score is the better the interest rate you’ll get.
Loan-to-value – Another determining factor is loan-to-value (LTV). LTV is the percentage of the agreed upon purchase price you’re able to put down at closing. The more money you put down, the more equity you have in your home which means less risk of default for the lender.
Property type and use – The property type you choose can also affect the rate you get. For example, condos tend to get a higher rate than single-family homes. Use of the property can impact the interest rate because lenders know a borrower is less likely to default on an owner-occupied home loan than a loan on an investment property.
Loan term – The length of time you choose for paying back your loan can impact your rate. A fixed-term loan over 15, 30, or 40 years will get you a better rate than an adjustable rate mortgage (ARM) — even though an ARM starts off with a lower or “teaser rate.”
It’s important to note that there are some factors that shouldn’t be considered by the lender in determining your final interest rate. The “Equal Credit Opportunity Act” (ECOA) of 1974 prohibits discrimination “on the basis of race, color, religion, national origin, sex or marital status, or age (provided the applicant has the capacity to contract)” or “because all or part of the applicant’s income derives from any public assistance program.”
Finally, you can pay to lower your interest rate. Known as a rate “buy down,” each discount point you purchase is equal to 1% of the total cost of the home. Purchasing points makes sense if you have the cash and plan to stay in the house for a extended amount of time. If you’re planning to move in five years, purchasing discount points is not worth the expense.
Today we have strong a economy with low unemployment, solid GDP growth, and inflation on or nearing 2%. And, while interest rates are still historically low, the Fed has announced the possibility of 3 rate hikes of a quarter basis point each this year. So, if you’re planning to purchase, now is the time.
While you may have no control over the economy or bond prices, always remember you do have control over your financial picture. Steady income, manageable debt, and most of all a good credit score will always get you a better interest rate. Finally, while not always accurate to the penny, you can use our loan mortgage calculator to experiment with different financial scenarios to get a feel for what your mortgage payment could look like.