Every home buyer hopes to secure the lowest interest rate for their mortgage loan as possible. Doing so requires an understanding of how those rates are set. Though its easy to blame our current high rate woes on lenders and banks, the process is complex involving many factors. Knowing those factors can help you set yourself up to negotiate the best rate possible. In a nutshell, your rate is determined by two types of factors:
- Mortgage rates are affected by personal financial factors, such as your down payment, income, assets and credit history.
- Mortgage rates are affected by market factors like inflation, the cost of borrowing, bond yields and risk.
Here are seven personal factors that affect your interest rate
1. Credit scores
Your credit score is one factor that can affect your interest rate. In general, consumers with higher credit scores receive lower interest rates than consumers with lower credit scores. Lenders use your credit scores to predict how reliable you’ll be in paying your loan. Credit scores are calculated based on the information in your credit report, which shows information about your credit history, including your loans, credit cards, and payment history.
Before you start mortgage shopping, your first step should be to check your credit, and review your credit reports for errors. If you find any errors, dispute them with the credit reporting company. The process isn't always a quick fix so make sure you start the process early.
2. Home location
Many lenders offer slightly different interest rates depending on what state you live in.
Different lending institutions can offer different loan products and rates based on the region you are shopping in. Regardless of whether you are looking to buy in a rural or urban area, talking to multiple lenders will help you understand all of the options available to you.
3. Home price and loan amount
Homebuyers can pay higher interest rates on loans that are particularly small or large. The amount you’ll need to borrow for your mortgage loan is the home price plus closing costs minus your down payment. Depending on your circumstances or mortgage loan type, your closing costs and mortgage insurance may be included in the amount of your mortgage loan, too.
4. Down payment
In general, a larger down payment means a lower interest rate, because lenders see a lower level of risk when you have more stake in the property. So if you can comfortably put 20 percent or more down, do it—you’ll usually get a lower interest rate.
If you cannot make a down payment of 20 percent or more, lenders will usually require you to purchase mortgage insurance, sometimes known as private mortgage insurance (PMI). Mortgage insurance, which protects the lender in the event a borrower stops paying their loan, adds to the overall cost of your monthly mortgage loan payment.
It’s important to keep in mind the overall cost of a mortgage. The larger the down payment, the lower the overall cost to borrow. Getting a lower interest rate can save you money over time. But even if you find you’ll get a slightly lower interest rate with a down payment less than 20 percent, your total cost to borrow will likely be greater since you’ll need to make the additional monthly mortgage insurance payments. Look at your total cost to borrow, rather than just the interest rate.
5. Loan term
The term, or duration, of your loan is how long you have to repay the loan. In general, shorter term loans have lower interest rates and lower overall costs, but higher monthly payments. A lot depends on the specifics—exactly how much lower the amount you’ll pay in interest and how much higher the monthly payments could be depends on the length of the loans you're looking at as well as the interest rate.
6. Interest rate type
Interest rates come in two basic types: fixed and adjustable. Fixed interest rates don’t change over time. Adjustable rates may have an initial fixed period, after which they go up or down each period based on the market.
Your initial interest rate may be lower with an adjustable-rate loan than with a fixed rate loan, but that rate might increase significantly later on.
7. Loan type
There are several broad categories of mortgage loans, such as conventional, FHA, USDA, and VA loans. Lenders decide which products to offer, and loan types have different eligibility requirements. Rates can be significantly different depending on what loan type you choose. Talking to multiple lenders can help you better understand all of the options available to you.
Market factors impacting mortgage interest rates
1. The Economy
What happens in the economy, and how those events affect investors’ confidence, influences mortgage pricing. Good and bad economic news has an inverse impact on the direction of mortgage rates. When the national economy is robust, and job growth high, mortgage rates tend to increase. This is partly due to investors deciding where to put their money; if they find more attractive returns elsewhere, the bond market will need to increase interest rates to compete, which results in costlier rates for borrowers. “Conversely, during economic downturns, mortgage rates tend to decline as money flows from more risky investments to more stable investments like mortgages,” says Scott Bridges, senior managing director of consumer direct lending for Pennymac.
2. Inflation
Inflation, the increase in the pricing of goods and services over time, is an important benchmark when measuring economic growth. Rising inflation limits consumers’ purchasing power, and that’s a consideration lenders make when setting mortgage rates. Lenders have to adjust mortgage rates to a level that makes up for eroded purchasing power when inflation rises too quickly. After all, lenders still need to make a profit on the loans they originate, and that becomes more difficult when consumers’ buying power is diminished. Likewise, inflation is a consideration investors make in the prices they’re willing to pay and the returns they demand on mortgages and other bonds they purchase on the secondary market. When inflation is elevated, investors commonly pursue investments that can beat or match its climb. This intensified demand for high yields means less-preferable mortgage rates for consumers.
3. The Federal Reserve
The Federal Reserve doesn’t set mortgage rates, but its monetary policy decisions definitely influence them. “The Fed can raise or lower short-term interest rates, which indirectly affects mortgage rates. When the Fed raises rates, it becomes more expensive for banks and lenders to borrow money; this translates to increased rates for borrowers. When the Fed lowers rates, it becomes cheaper to borrow money, resulting in lower mortgage rates,” says Bridges. For example, as the Fed began hiking interest rates in 2022, in an effort to squelch inflation, mortgage rates rose first in response, and then in anticipation of, the central bank’s moves.4.
4. Financial markets
The performance of T-bonds and mortgage-backed securities plays a role in your mortgage’s interest rate. “Because mortgages are packaged together into securities and sold as mortgage bonds, it’s the return investors demand to buy these bonds that dictates the general level of mortgage rates,” says Greg McBride, CFA, Bankrate’s chief financial analyst. Mortgage rate levels are priced above that of the 10-year Treasury; the spread between them reflects the risk that investors bear for holding those bonds. “It may seem counterintuitive that 30-year mortgage rates are priced relative to yields on 10-year Treasuries,” says McBride, “but when these 30-year mortgages are packaged together into bonds, on average, they tend to pay out over a 10-year period as homeowners refinance, move or otherwise pay off their loans early.”
5. Government policies
If the federal government produces policies that promote homeownership, such as down payment assistance or tax credits, it can stimulate demand for mortgages and possibly lead to higher rates.
6. Global and/or political events
“A financial crisis in another country, for example, could send investors flocking to U.S. bonds as a safe haven, driving down their yields and, in turn, mortgage rates,” says Shirshikov.
Bottom Line
Understanding the factors influencing mortgage rates, identifying those in control, and recognizing variations tied to lenders and loan products empowers you as a well-informed borrower. However, attempting to time the market is usually ill-advised. If purchasing a home aligns with your current needs, focus less on market trends or economic predictions. Instead, initiate the process of exploring financing options by actively shopping around.
Source:
https://www.bankrate.com/mortgages/how-interest-rates-are-set/
