How Are Mortgage Interest Rates Determined?
You may have seen certain peculiarities if you are in the market for a mortgage or refinancing rate.
Rates might vary significantly amongst lenders. Occasionally, refinancing rates differ from purchase rates.
And mortgage rates may appear far higher than they did yesterday.
With so many moving parts, navigating the market and obtaining a reasonable rate can take time and effort.
But if you understand how mortgage rates are decided, you can shop like a pro and save significant money over time.
The Three Elements That Influence Mortgage Rates
Three elements affect the interest rate on your mortgage or refinancing.
- The economic climate
- Your mortgage lender
Each of these characteristics will be described in depth below. But here’s a quick summary of how these three factors interact to determine your mortgage rate:
- The strength of the U.S. economy mainly determines mortgage rates. When the economy is robust, interest rates tend to increase. When the economy is sluggish, interest rates tend to decline.
- Individual factors impact whether your mortgage rate is on a high or low end of the spectrum. For instance, suppose the economy is in a low-rate phase, with average 30-year loan rates hovering around 3%. A borrower with excellent credit and a substantial down payment may receive a rate closer to 2.5%, but a person with poor credit may be given 3.5%.
- Lenders provide varying interest rates to various customers based on the sorts of loans they specialize in and their capacity for new business. Therefore, it is essential to compare mortgage rates from many lenders.
This final aspect is likely the most crucial if you are comparing mortgage or refinancing rates.
You cannot alter the rate environment as a whole. And until you have a few months, it isn’t easy to significantly improve your credit score or save for a larger down payment.
However, you may always compare multiple lenders.
There is a lesser rate available than your initial one. You must search for it.
How Economic Conditions Impact Mortgage Rates
At any particular time, the health of the U.S. economy and investor confidence decide whether we are in a “high-rate” or “low-rate” situation. Here is how it operates.
Mortgage-Backed Securities (MBS) Dictate Mortgage Interest Rates
The first thing to know is that lenders hold the majority of mortgages for a little duration.
Soon after closing, mortgages are frequently packaged with other mortgages and sold to investors on the secondary market. Thus, the lender will have more funds to lend to the subsequent borrower.
Each package is referred to as a mortgage-backed securities (MBS). A mortgage-backed security (MBS) is a form of bond: a fixed-income financial instrument that may be purchased by investors worldwide.
How the MBS Market Influences Interest Rates
Lenders watch the secondary market where MBS are exchanged continuously.
On many days, MBS prices fluctuate by the hundreds. And if these fluctuations are significant, lenders may alter their rates frequently to stay up.
When demand for (and the price of) mortgage-backed securities (MBS) rises, mortgage rates often fall.
This frequently occurs when the economy is unclear or declining.
These times, investors want a secure investment, and MBS are often a safe option. As a result, more money will enter the mortgage market, driving rates for borrowers to plummet.
For a concrete illustration of this, consider what the Federal Reserve did to mortgage rates during the coronavirus outbreak.
The Federal Reserve’s New Involvement in Setting Mortgage Rates
As soon as the Covid-19 outbreak became widespread, the Federal Reserve acted promptly to stabilize markets and restore trust. Much of this was used to purchase other bonds, notably MBS.
Typically, the Fed does not participate in determining mortgage rates. Even when it modifies its rates, it does not directly impact house loan rates.
It may alter the sentiment of MBS secondary market investors. However, you should not expect to pay less for a new mortgage just because the Federal Reserve reduces interest rates.
However, by purchasing more than $1 trillion in MBS, the Fed has had an almost imperceptible but direct effect on mortgage rates.
Such a significant new buyer drives up MBS values, hence decreasing yields and mortgage rates.
Keep an Eye on the News if You Are Comparing Rates
When attempting to comprehend how mortgage rates are established, it is evident that the economy plays a significant role. When the economy is growing, mortgage rates tend to be high. When it’s in jeopardy, it’s generally at a low point.
This is true daily. An unexpectedly positive economic report can increase mortgage rates, while negative news might decrease them.
For this reason, keeping an eye on the news while comparing mortgage rates is essential. You must be prepared to lock when the timing is right, as they might drop at any time.
How Do You Affect Your Mortgage Interest Rate
Lenders give applicants rates that vary significantly.
You will also discover that different lenders will offer you different interest rates, even if you provide them with identical information.
This is because lenders evaluate borrowers based on their own criteria. Based on each lender’s methodology, you may be labeled as a safe or riskier borrower, and your interest rate will be adjusted appropriately.
Lenders use three primary factors to determine the interest rate they will give you:
- Your credit rating and history: Your prior debt management performance is the strongest indicator of how you will handle your new debt.
- Your down payment (also known as the loan-to-value ratio or LTV) — The more your contribution to the acquisition, the less the lender will lose if something goes wrong.
- How much your existing obligations weigh on you (also known as “debt-to-income ratio” or “DTI”) — A mortgage and other housing expenses may be the last straw for someone who is trying to keep up with existing monthly obligations.
If you have the time, you can improve all three of these. You may improve your credit score, accumulate a larger down payment, and reduce debt.
It isn’t easy to execute all three at once. And no one anticipates miracles. However, modifying one, two, or all of these factors might result in a cheaper interest rate and monthly payment.
The Other Factor That Influences Your Mortgage Rate
Your willingness to compare mortgage offers can make a significant difference in terms of reduced interest rates and monthly payments.
In 2016, the Consumer Financial Protection Bureau (CFPB), a federal regulator, conducted research that revealed 30% of borrowers did not shop around for their mortgage. Worse, over 75% were applying to a single lender!
The CFPB report continues:
“According to previous Bureau data, neglecting to comparison shop for a mortgage loses the average homebuyer around $300 annually and tens of thousands of dollars over the life of the loan.”
Therefore, it is worthwhile to browse and locate the lowest rate. You may comparison shop in a single day and likely get a better value than your initial offer.
Why Lenders Provide Varying Interest Rates to Specific Borrowers
We’ve addressed the primary aspects of our first inquiry, “How are mortgage rates determined?”
However, there needs to be more to explain why several lenders offer the same borrower such drastically varying interest rates. So let’s address this.
Different lenders prefer to specialize in distinct borrower groups.
Therefore, specific lenders may build a niche market by giving bargains to the borrowers with the best credit.
Others may assist those with difficult scores as low as 500.
And other lenders specialize in particular lending programs, such as mortgages for self-employed borrowers or jumbo loans.
If your credit score is 580 and you apply to a lender that specializes in consumers with excellent credit, you will likely be denied. Or you may be quoted an excessively high price intended to dissuade you.
The same holds if your credit score is 800 and you apply to a lender accustomed to assisting folks with low credit ratings. You will certainly be offered a loan, but the interest rate may not be optimal for a borrower like you.
Another Cause for Rate Discrepancies Among Lenders
Lenders can also adjust mortgage rates based on their existing volume of business.
When loan officers and systems are overworked with new loan applications, lenders are sometimes compelled to discourage new applicants. They achieve this by increasing their charges.
Lenders are unlikely to respond with “We’re too busy for you” or “We don’t have enough money to lend you at the moment.”
Instead, they offer you inferior bargains. And if that doesn’t work, they’ll find a way to accommodate you and keep the additional earnings you’ve given them.
Even if you truly like your current lender, you should look around for your new mortgage or refinancing.
In addition to the possibility that your financial situation has changed after you filed for your present loan, you would benefit from a different one.
However, yours may not be as competitive as they were when you initially began working with them.
Are Mortgage and Refinancing Interest Rates Identical?
Mortgage and refinancing rates are often comparable. Therefore, a 30-year fixed-rate mortgage for a home purchase should have a rate similar to a 30-year fixed-rate refinancing.
Occasionally, though, mortgage and refinancing rates diverge. Typically, one of the following two reasons:
Excessive demand for purchase and refinancing loans: As we’ve demonstrated, lenders may increase interest rates to discourage demand. And, if a refinance causes a lot of effort (as it generally does), the lender may charge extra.
One is more lucrative than the other – Lenders are not charitable organizations. They will prioritize house purchase mortgages above refinances or vice versa to maximize their profits.
How Frequently Do Mortgage Rates Fluctuate?
MBS prices and yields can fluctuate hundreds of times within a hectic day. This secondary market is similar to stock markets in this regard.
Indeed, lenders do monitor developments in real-time. However, they release only a few new rates daily.
When the secondary market is calm, they may only release one new rate sheet, if any.
A lender may publish morning and afternoon rate sheets if the MBS market is somewhat more volatile. However, the volatility must be high to push out many more.
What Factors Influence the Growth and Decrease of Mortgage Interest Rates?
In normal circumstances, mortgage interest rates are heavily influenced by investor expectations.
Good economic news hurts interest rates because an active economy boosts inflation fears.
Inflation causes fixed-income instruments such as bonds to lose value, which increases their yields (a synonym for interest rates).
For example, imagine you purchased a $1,000 bond with 5% annual interest ($50) two years ago. (This is referred to as the bond’s “coupon rate” or “par rate” since you paid $1,000 for a $1,000 bond and its interest rate is equal to the rate mentioned on the bond, in this case, 5%).
Your interest rate: $50 annually divided by $1,000 equals 5%
When Mortgage Interest Rates Decrease
Today, this pricing is quite attractive; many people want to purchase it from you.
Your $1,000 bond may be sold for $1,200. The buyer receives the same annual interest payment of $50 as you did. 5% of the $1,000 discount remains. However, since he spent more on the bond, he received a smaller return.
Your buyer’s interest rate is calculated as follows: $50 yearly interest / $1,200 = 4.2%
The buyer receives a yield or interest rate of 4.2%. Therefore, interest rates fall as bond demand grows and bond prices rise.
If Mortgage Rates Increase
However, if the economy heats up, the possibility of inflation becomes bonds less desirable. With fewer individuals desiring to purchase bonds, their values fall, followed by an increase in interest rates.
Imagine owning a $1,000 bond, but you cannot sell it for $1,000 since the unemployment rate has declined and stock values are rising. You end up getting $700. The buyer receives the same $50 in annual interest, but the yield is as follows:
$50 yearly interest divided by $700 is 7.1%
The buyer’s interest rate has since increased. Interest rates and returns are not a mystery. They are calculated using elementary math.
When to Lock In Your Mortgage Rate
How do you know when to lock in a mortgage rate if they’re constantly fluctuating?
Fortunately, it is easier than it seems.
You’ll likely have a brief opportunity to compare rates before it’s time to lock and close the deal.
And at that period, you should anticipate rates to stay the same. Typically, day-to-day fluctuations are negligible.
Therefore, the decision is less about the time of your rate lock and more about selecting the appropriate lender.
Since even seasoned economists have difficulty predicting the movement of mortgage rates, you will likely save more by shopping around than by trying to play the market.