Are you becoming puzzled about interest rates and how they are determined? One of my newer clients, who is a first-time homebuyer, was asking me recently about APR vs. interest rates, why it seems that they fluctuate constantly, and what a lender looks at to determine what rate you will be charged for borrowing money (and I’ll have another email coming sometime soon regarding how a lender can actually help to get you the home that you want, or hinder your offer so another buyer wins…this is bigger than you think).
So I posted this article on my website to provide you with some helpful information on this topic….even included a Dave Ramsey tip in there for ya, to save you thousands of dollars over the life of the loan. 😉
Sooooo….the big question I’m asked a lot is “will they go up again?”. Not surprisingly, with rumors of several interest rates hikes in the works for 2018, it’s the top-of-mind question for lenders, real estate professionals and real estate purchasers. 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 what the Fed is doing. 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. Speaking with a successful lender and finding out the options and offers that you qualify for is a critical step if you hope to keep your monthly mortgage rates as low as possible.
While interest rates vary from person to person, and 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 on the secondary market. Without getting too technical, the secondary market is the place mortgage banks turn to sell their loans (anyone see “The Big Short”? This may bring up some flashbacks…). 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 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. Buyers that put down 20% down payment (80% loan to value) or more will avoid paying the lender Private Mortgage Insurance (PMI) fees. However, if you have poor credit or are otherwise considered a high risk to the lender, you may be required to carry PMI even if you have a 70%, 60%, or even 50% loan to value ratio. This is something that I didn’t even know about until I chatted with my preferred lender.
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. To be honest, though, these loans are not looked upon favorably in our current marketplace, as they are considered more risky to a seller (buyers have “less skin in the game” and are generally in a tighter financial situation), and conventional loan offers are usually selected over FHA or VA offers when in a multiple offer situation.
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, it offers the borrower a wealth of savings. Plus, if you’re a Dave Ramsey fan, you already know that it comes highly recommended! Dave says the solution to buying a home, when you can’t buy all-cash, is to stay away from being “house poor”, where your budget is pushed to the limit, and you then can’t save or purchase needed items (including future education). How do you do that? He suggests saving a down payment of at least 10% on a 15-year (or less) fixed-rate mortgage, and limit your monthly payment to 25% or less of your monthly take-home pay.
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. This can be scary, yet some lenders that I have spoken with think it is a good fit for some buyers, as many will not be staying in the condo that they are purchasing for 30 years. One of my clients likes the lower rate of an adjustable, making his payments more manageable, and knows he’ll be selling within 10 years, so the 10/1 ARM was a better fit for his needs.
The annual percentage rate
When comparing interest rates and options from lenders, pay attention to the annual percentage rate (APR) quoted in each loan offer. 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 loan product.
And know that part of my job is to assist with educating and arming you with info, so please don’t feel any pressure (many of my clients are 6 months to over a year out) and always let me know how I may help. 🙂