Will they go up again? It’s the top-of-mind question for lenders, real estate professionals, and real estate consumers. When interest rates take a hike, the complexion of the housing market completely changes.
If you’re a first-time homebuyer, you are no doubt following interest rates and the doings of the Fed. It’s confusing, isn’t it? Real estate industry jargon is bad enough but with mortgage lingo thrown in, it’s no wonder homebuyers don’t know where to start.
Because interest rates fluctuate daily, it’s important to shop for a loan quickly, yet effectively. Comparing lenders’ offers is a critical step if you hope to keep your monthly mortgage rates as low as possible.
While interest rates are but one aspect of a mortgage quote to compare against others, it is probably the most important, so let’s take a look at why rates change and what you can do to get the lowest rate.
What impacts mortgage rates?
The Federal Reserve System, also known as “The Fed,” is the U.S. central banking system, controlling the way money moves in and out of our country’s financial system.
The Fed is governed by a seven-member Board of Governors and includes 12 regional Federal Reserve Banks. Within this group are committees; the most significant of which to a discussion of mortgage interest rates is the Federal Open Market Committee or FOMC.
The members of the FOMC are tasked with figuring out the Fed Funds Rate – the interest rate charged to banks when they borrow money. Banks that lend to other banks also use this rate. In turn, this is the base rate banks use when they determine how much to loan to their mortgage customers.
The secondary market’s impact on mortgage rates
Mortgage rates also fluctuate according to what is happening in the secondary market. Without getting too technical, the secondary market is the place mortgage banks turn to sell their loans. Without these sales, the mortgage banks couldn’t remain in business as they lack long-term funding. So, this is the only method they use to create more money to lend. Mortgage bankers also make a commission on each loan sold.
So, who buys these loans on the secondary market? Investors include pension funds, securities dealers, other banks, Freddie Mac, and Fannie Mae (with certain restrictions).
How your interest rate is determined
While the Fed and the markets set the starting point for a bank’s determination of interest rates for their customers, the rate offered to you is determined on a much more personal level.
Your credit score, determined by the Fair Isaac Corporation (FICO), has the most significant impact on the rate you’ll be offered.
FICO considers many things when determining your credit score. The two items that most impact your score, however, are your payment history and the amount owed.
The FICO score is a three-digit number – between 300 and 850 – and it signifies, to lenders, your reliability in repaying your debts. A low score may mean that you won’t get the loan or you’ll receive a high-interest rate. A higher score means you’ll have more options available. Fortunately, FICO scores, like interest rates, fluctuate so it’s possible to raise your score.
While FICO only considers information in credit reports, your lender will look at far more.
Income and assets
Your job, and your time on the job, also impacts the amount of interest you’ll pay on your mortgage loan. A two-year history in the same line of work, whether as an employee or self-employed – shows the lender’s income stability.
Lenders also look at earned investment interest, royalties, and commissions. It may also consider income from Social Security, child support, and alimony.
The lender will use your income and debt numbers to calculate your debt-to-income ratio, which should not exceed 36 percent of your gross (pre-tax) income. The ratio is further broken down, looking to ensure that you spend no more than 28 percent on housing and 8 percent to pay off debt, such as installment loans and credit card balances.
Learn how to calculate your debt-to-income ratio at bankrate.com.
Consumers who make large down payments on their homes are typically more likely to continue paying for the home since they have so much invested in it. Lenders often offer a lower interest rate when the customer is willing to make a large down payment.
Because the government guarantees repayment, a government-backed loan, such as FHA, VA, or USDA, will have a lower interest rate than a traditional mortgage loan. Even customers with what may be described as a “risky” credit history may be offered a loan because the lender isn’t on the hook for the entire balance should the borrower default on the loan.
Length of the loan
Lenders know that the likelihood of default rises the longer a borrower holds a loan. For this reason, a 30-year fixed loan bears a higher interest rate than a 15-year fixed. Not only does a 15-year mortgage allay lender fears, but it also offers the borrower a wealth of savings.
Type of loan program
While there are many loan programs available, the two most commonly offered to homebuyers are fixed-rate and adjustable-rate loans.
With a fixed rate, your mortgage interest rate remains the same for the life of the loan. Borrowers like this program because their mortgage payments remain predictable until the loan is paid off.
The adjustable-rate mortgage (ARM), on the other hand, has fluctuating interest rates at pre-determined intervals. For example, a 5/1 ARM has a fixed rate for five years and then adjusts, either up or down depending on current rates, every year.
The annual percentage rate
When comparing interest rates of various lenders, pay attention to the annual percentage rate (APR) quoted in each offering. This number represents the annual cost of the mortgage with interest, points, and mortgage insurance factored in.
While mortgage interest rates are an important consideration when comparing offerings from various lenders, they are only one factor to consider. You should compare all loan features, such as points and closing costs, before settling on a lender and a loan product.
I have a client who just got a conventional loan with 5% down and got an interest rate of 3.99% (as of May 20, 2017) because his credit score is very good. If yours is not quite in the mid 700’s you might expect it to be closer to 4.5%.