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How Are Mortgage Rates Determined

Posted: 2018-12-05 | Author: Scott Roberts


For consumers in our society, credit is often needed to make necessary purchases. There is a strong argument that our society is too dependent on credit, and most households have more unsecured debt (e.g., credit cards, personal loans, etc.) than they should have. There are some purchases, however, that are very difficult to make without credit. The best example of this is a home mortgage.

Today, the cost of most homes runs well into the six figures. And unless someone is independently wealthy or already has a home that is paid off, they are probably going to have a hard time purchasing a new one without some type of financing in place.




From the consumer’s standpoint, one of the most important aspects of their home mortgage is the interest rate. Interest rates play a major role in determining the overall cost of the loan, the monthly payment, and ultimately, how much the buyer can afford to borrow. Naturally, everyone wants the lowest interest rates. Toward that end, it is helpful for borrowers to know how mortgage rates are determined.

Factors that Determine Mortgage Rates for Borrowers
When you take out a mortgage, the lender is taking a risk on you. This risk is reflected in the interest rate you will pay. In general, the greater the risk, the higher the rate will be. But this formula is more complicated with mortgage rates than most other types of consumer loans. There are many factors that are within the control of the borrower, and there are also some external factors that help set the market rates.

Here are some of the factors that are largely within the borrower’s control:

Credit Scores:
Your credit score is used to predict how reliable you will be in paying back your loan. The higher the credit score, the lower the risk for the lender, and as such, the lower your interest rate will be. Before shopping for a mortgage, it is best to check your credit report and look for any errors that may be hurting your score. You can dispute any errors and have them removed, which can raise your score and put you in a position to obtain a better interest rate.

Down Payment:
Generally, the higher the down payment, the lower your interest rate is likely to be. Lenders see a higher down payment as a much lower risk, because the borrower has some “skin in the game”. In addition, there is more equity in a home that is financed with a higher down payment, which protects the lender in the event of a default. A large enough down payment (generally 20% or higher) can also remove the need for private mortgage insurance (PMI), which is a monthly payment that borrowers often have to make to insure the mortgage holder against a loan default.

Home Price and Location:
Interest rates might be higher if you are borrowing an unusually low amount or an unusually high amount. Loans that are higher or lower than the established norms are seen as riskier for the lender. The state you live in also matters to the lender. Rates tend to fluctuate slightly from state-to-state.

Term of the Loan and Rate Type: The interest will depend on how long the loan is for. A general rule is the longer the term then the higher the rate. For example, you will get a better rate on a 15-year mortgage than the standard 30-year term. The rate type is also a factor. Most people prefer the certainty of a fixed rate mortgage. However, some might opt for an adjustable rate mortgage (ARM), which is low for a certain period, then adjusts higher. This can be good for investors who want to fix up and flip a property, and possibly for buyers with imperfect credit who want a lower adjustable rate while they rebuild their credit in the hopes of refinancing to a fixed-rate mortgage later on. Lenders might also lower your rate in exchange for higher closing costs, or vice versa.

Type of Loan Program:
Rates can fluctuate depending on the type of loan program the borrower is using. The most common types are conventional, FHA, USDA, and VA loans. Be sure to work with a lender who has in-depth knowledge of all of these (and other available programs) and can work closely with you to find the program that best suits your needs.

External Factors: A Tangled Web
There is no one external factor that sets the market rate for mortgages. For example, mortgage rates are not determined by the Federal funds rate that is set by the Federal Reserve (although that is an indirect factor). Mortgage rates are determined by many factors that converge to help set the current market rates.

One of the most important factors in determining the interest rate on mortgages is the rate of inflation. When the economy is on the upswing (which is what we are currently experiencing), inflationary pressures tend to impact the market. The lender sells most mortgages to investors in the secondary market, and these investors want to put their money where it is likely to yield the highest potential return for the lowest risk. When the rate of inflation rises, the money consumers borrow will be worth less as they pay it back over time. For this reason, investors will insist on higher mortgage rates to make up for this loss.

Contact a Local Lender for the Best Loan Programs and Mortgage Rates
If you are shopping for a mortgage to purchase a property or refinance your current mortgage, it is best to work with a local mortgage lender. Local lenders have access to the same programs that you can get through a national lender, and they can provide the most competitive mortgage rates available (based on what you can qualify for). A local lender can also provide highly personalized service and work closely with you from start to finish to help ensure that you are able to successfully obtain the financing your need.

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