One of the most pressing concerns for first time buyers of homes is understanding how interest rates are determined. While most new buyers of homes understand that the mortgage interest rate will directly affect their monthly payments, there’s still a lot of confusion about how the rate is determined to begin with. Here are the basics, and how to can use this information when looking at homes to buy.
How Does the Federal Reserve Impact Mortgages on Homes?
Basically, the Federal Reserve is the entity that determines the interest rates that banks charge each other when they borrow and loan money. How does this affect the amount of interest your mortgage lender charges you? Well, it’s the basis for the prime lending rate, or the interest that banks charge their most reliable customers. Prime is usually about 3% above the bank rate. If you loan is somehow tied to the Prime Rate then this will have a direct impact you. Prime is not the rate most loans are tied to however. Prime is usually associated with Home Equity Lines of Credit.
The more common purchase money and rate and term refinance mortgages, 30 and 15 year fixed for example, are priced completely differently. These loans are more closely tied to supply and demand of the 10 year treasury bond and the correspnding yield. If demand fades, bond dealers have to lower their price of a bond to sell it on the open market. When the price of the bond is reduced, the income stream (interest payments) remains the same and becomes a higher percentage of the bonds value (yield). Here is an example: a $1,000 bond pays $50 a year (5%). If a buyer is concerned about inflation in the economy getting close to the 5% number….he is going to want a bigger return on his investment so his demand for a $1,000 5% bond is going to reduce. A seller of that bond might have to reduce the price to $900 in order to sell it. The %50 dollar a year interest payment against a $900 price is 5.56% yield which would hopefully attract the buyer.
When the market is such that demand for bonds is decreasing because of inflation concerns for example, yield requirements are going to be going up and this will also push up the rates offered by mortgage lenders as, just like bonds, mortgage loans are sold in much the same way bonds are sold…..they are bundled together and sold as mortgage backed securities. So when you hear the phrase “The Fed Lowered the Rate” or “The Fed Increased rates” understand that this may not affect the typical mortgage rate pricing.
There are other factors that can influence mortgage rates. The most common factor is what is called “Risked Based Pricing”. Risked Based Pricing is pricing that takes into account the FICO credit scores of the borrowers. The lower the scores the higher the risk and the higher the mortgage rate. Yes, when it comes to lending- credit scores are king. From the lenders point of view, the best indicator of whether or not you will honor the terms of your home loan are how well you have dealt with past creditors. If you don’t already know your FICO (Fair Isaac Corporation) score, you need to become very familiar with this number. It’s determined by your credit history, amount owned, how often you apply for cards, length of credit history, and mix of credit types. You want the highest FICO score possible. If it’s low you need to read about ways to improve your credit score. This will increase the number of homes available to you. Mortgage rates can also be influenced by the region the property is located in. For example, California and Florida have traditionally held dubious distinctions of generating more mortgage fraud (and therefore loss) than other states. So as a result mortgage pricing for Florida and California loans typically are higher than a state like Virginia.
Mortgage rates can also be influenced by the region the property is located in. For example, California and Florida have traditionally held dubious distinctions of generating more mortgage fraud (and therefore loss) than other states. So as a result mortgage pricing for Florida and California loans typically are higher than a state like Virginia.
What this means for buyers of homes is that your individual rate is determined by the spread of rates in your area. Your mortgage lender will set your interest rate based on these key factors: your credit history, income, outstanding debt, and the types of loans for homes you are seeking. Your income and outstanding debt will impact your interest rate when obtaining your homes mortgage. In many situations using cash on hand to pay off debt, rather than making a larger down payment, can lower your interest rate.
Finally, the type of home loan you seek will influence your homes mortgage rate. The traditional 30-year conventional mortgage is likely to have a higher interest rate than an ARM (adjustable rate mortgage). Of course, the ARM is subject to change, so it’s a bit riskier. You will want to consult a mortgage lender to determine what type of home loan is best for your personal situation.
First time buyers of homes and seasoned pros need to know how interest lending rates are determined to getting the best rate possible. For questions please contact [email protected]