Understanding mortgage rates

When shopping around for mortgage rates, there’s probably a temptation to think that lenders are setting these things quite arbitrarily. However, there are actually two main facets to determine the interest rate on a mortgage: market conditions and your personal financial profile.

Base market rate and Federal Reserve

Dating from its original congressional tenure, the Federal Reserve is the central bank of the United States. This means that he has various responsibilities, including the supervision of banks as a whole and the establishment of certain rules of financial policy. But perhaps the most important role it plays from a consumer perspective is in setting short-term interest rates.

When the Fed’s Open Market Committee (FOMC) meets to determine what the federal funds rate should be at any given time, it has some key objectives:

• Achieve as many jobs as possible
• Keeping prices stable (i.e. keeping inflation at bay)

The Fed has a bit of a balance here because these goals sometimes compete with each other. To get the highest possible employment rate, you can choose to keep interest rates low, as cheaper loans can encourage companies to invest. This can lead to more hires as well as more money spent on goods and services, which can have a ripple effect and help even more businesses thrive.

However, if the cost of borrowing is too low, it also means that the money you saved in the past is worth less than if higher borrowing costs made funds scarce. If your money is not worth that much, the prices can go up quickly, as you have to part with more money to receive the same value. Pretty soon you end up paying $ 15 for a loaf of bread.

It should be noted that a little inflation can be a good thing, as the threat of a price hike can cause people to buy now rather than waiting indefinitely in the future, thus boosting activity. economic. But it’s important that the Fed keeps a thumbs up. Recently the target inflation target was 2% per year.

The Fed must do its best to maintain a balance between these two factors when setting the benchmark short-term interest rate, which is the rate at which federally insured banks can borrow money every night. . the current range of Fed funds rate is 0% to 0.25%

While the most immediate impact may be felt in the rates of short-term loans – credit cards, personal loans, and automobiles – long-term repayments like mortgages tend to correlate with these short rates. term. Depending on market factors, which we discuss below, the base interest rate on a mortgage can be 2% to 3% higher than short-term rates.

Base market rate And Bond trading

When the practice of lending people money to buy a house began, a bank would examine the credentials of the borrower and, if they made a loan, would hold it until the loan was repaid, potentially. 20 or 30 years later. line.

While some banks still do this today, the advent of MBS changed things a bit. Let’s take a quick look at how the process works.

After your loan closes, it is combined with other mortgages that have similar characteristics to your loan. For example, a single MBS can have 100 conventional loans with credit scores over 680 and down payments between 15% and 20% on major properties.

The investor – most often an institution, but it may be an individual – has the option of buying it at a market-dictated rate of return. It is these rates of return that are important in determining mortgage rates.

The advantage of this system for a mortgage originator is that he can receive money from a mortgage investor who supports the bond and conditions it in the form of MBS, which gives him the necessary capital to make more. loans without having to wait for payments to be made in full during the term. For a consumer, more loans are available on favorable terms.

The stock and bond markets tend to operate with a push-pull effect. Stocks are considered riskier because they are fueled by company results and, more often than not, by speculation about what a company will or will not do in the future. They are a bit more speculative, but they can offer a higher rate of return in exchange for increased risk.

Bonds, on the other hand, could span anything from local municipal projects to large-scale government operations to mortgage bonds – the last of which are paid each month when the owners make their payments. Since the borrowings that underpin bonds tend to be for essential goods and services, this is considered a much safer investment in stocks because people will be paying for necessities.

This is where push-pull comes in. When stocks go up and people feel good about the business and economy, they put more money in stocks and take out bonds. Since MBS are traded in the bond market, mortgage rates tend to rise as the rate of return on bonds needs to be higher to attract investors. On the other hand, if people are uncertain about the future at home or abroad, the money returns to the safety of the bond market, which can have the effect of lowering mortgage rates.

In addition to setting monetary policy, the Fed has also played a role in recent years. Because housing plays a key role in the economy, the FOMC chose to dive into the bond market, buying MBS with the aim of supporting and sustaining the low mortgage rate environment. The committee has ramped up purchases of MBS in response to COVID-19. The Fed’s MBS holdings are sitting around $ 2.04 trillion at the time of this writing.

If all things were equal, the movement of the bond market one way or another on any given day would determine your mortgage rate. However, your personal financial profile is also taken into account. Let’s move on to that next:

Your personal interest rate

An important thing to remember about mortgage rates is that in addition to market factors, they are also determined in part by the level of perceived risk. If you are considered a lower risk, you will get a better rate than someone with higher risk factors.

Some of the risk-based metrics lenders use to reassess your qualifications include:

Another thing that can impact your rate is the closing costs associated with your loan. Let’s briefly go through a few examples:

Prepaid interest or mortgage discount points are a way to lower your interest rate. One point is equal to 1% of the loan amount. Making sense of buying points involves doing a little math.

Let’s say you buy a house for $ 200,000 and pay 2 points to save $ 50 on your monthly payment. Since the cost of the points would be $ 4,000 (200,000 * 0.02), you divide that number by 50 to get the breakeven point: 80 months. In other words, if you plan to stay in the house for more than 6 years and 8 months, it may be a good idea to buy the points because you will save money over time. Otherwise, you shouldn’t buy the points, or you should buy fewer points.

On the other hand, if you want to reduce closing costs, you can opt for a loan from your lender for roll the closing costs into the loan in exchange for a slightly higher rate.

Finally, if you make a down payment of less than 20%, you will probably have to pay for mortgage insurance or an equivalent. The exception to this is VA loans, which have unique upfront finance charges that can be built into the loan if you wish.

With conventional loans, you have the option of making the mortgage insurance payment on a monthly basis or having the lender prepay the policy and take a slightly higher interest rate than loans without. mortgage insurance paid by the lender (LPMI). However, there is also single payment mortgage insurance. With this option, you can pay part or all of your mortgage insurance policy up front to get a lower rate while avoiding a monthly mortgage insurance payment.