When you’re ready to enter the market to become a homeowner, you’ll need to know about interest rates, otherwise known as mortgage rates. A higher interest rate will mean higher monthly payments and a larger total loan amount, which means you’ll want to pay close attention to these rates before you commit to your loan.
But how are mortgage rates determined when applying for a home loan? Here, we’ll take a look at how various factors affect and determine your mortgage rate.
Key Factors Influencing Mortgage Interest Rates
Two key types of variables impact mortgage rates for borrowers: economic factors and borrower-specific factors. Economic factors include things like Federal Reserve policy, the bond market, inflation, and the state of the local and national economy. Borrower-specific factors are based on the financial situation of the individual applying for the loan
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The Role of the Economy
Economic indicators measure the health of a society based on commerce and other market factors. Average income, average spending per capita, unemployment rate, and business growth rate all have an impact on the greater economy and, therefore, the real estate market.
Here are some of the elements that can affect mortgage rates for homebuyers no matter where they live.
The Federal Reserve
The Federal Reserve, often referred to as “the Fed,” is the central banking system of the United States. It sets the Federal Reserve monetary policy and controls interest rates for the entire economy. Most significantly, the Federal Reserve controls the money supply in the country, which includes everything on its balance sheet. That means that things like the amount of currency in circulation and the size of deposits in Federal Reserve-backed financial institutions all impact the current state of the economy.
The Fed’s primary objective is to keep the economy stable, neither allowing hyperinflation nor pushing the economy into a depression. It does this by raising and lowering interest rates, purchasing assets, and determining how much banks must keep in reserve.
Lenders that give out money to borrowers tend to follow suit when the Fed lowers rates or raises them. Therefore, if the Fed raises interest rates for borrowing, mortgage lenders do the same to keep up with demand. The rate the Fed controls is known as the federal funds rate, which is among the major factors impacting mortgage borrowers.
The Bond Market
The bond market is made up of mortgage-backed securities (MBS) and treasury bonds. These are low-risk options for mortgage investors that compete and have a direct impact on the mortgage rate market. Typically, when bond or mortgage-backed security prices are low, mortgage rates are up. Similarly, when those prices rise, it may indicate the average interest rate for a mortgage has decreased.
Inflation
Inflation is an economic process where the buying power of currency is diminished. Put simply, your dollar does not go as far when inflation is high because its purchasing power has decreased. When inflation rises, demand for mortgage bonds falls, sending interest rates for mortgages up. The Consumer Price Index measures the forecast for inflation and economic growth, so it’s a good place to look when evaluating the future of mortgage rates as you begin your search for a home loan.
Economic Growth and Outlook
In a strong economy, mortgage rates tend to be lower because people have an easier time paying their debts. A recession, on the other hand, will force mortgage lenders to charge higher interest rates because the risk of borrower default is greater. Gross domestic product (GDP) is another indicator to track. If GDP is stable and growing, you will likely find a lower interest rate when you borrow money to buy a home. However, if GDP is high, the Fed could react by raising the interest rate to slow down borrowing.
Job growth also plays a role in mortgage rates. A strong labor market signals to lenders that they can charge more for a mortgage loan, causing mortgage rates to climb. If the job report outlook is negative, the Fed may attempt to stimulate homebuying by reducing the interest rate. Therefore, the state of the greater economy is an important indicator of mortgage rates.
Borrower-Specific Factors
In addition to economic indicators, lenders assess personal factors related to your financial health and stability to determine risk when lending to borrowers. The more risk you pose as a borrower, the more likely you are to receive a mortgage offer with a high interest rate.
Here, we’ll examine the borrower-specific factors that can affect your loan’s mortgage rate.
Credit Score
Credit scores are incredibly important to lenders in the real estate industry. Your credit history is a reflection of your reliability in paying back debts. A credit score incorporates your payment history, credit length, number of open accounts, types of credit, missed payments, revolving utilization, and many other factors to calculate a final number.
Your FICO credit score will impact the types of loans you can qualify for, as well as the mortgage rates attached to those loans. For example, a higher credit score of 620 or more will qualify you for most conventional loans. Lower credit scores may force you to seek out other loan options like FHA mortgages or USDA mortgages.
Once you apply for a mortgage loan, your lender will use your credit score to offer a competitive mortgage rate based on your personal factors. If you have positive credit reports and a high credit score, your risk as a borrower will be low, and the lender will likely offer you a lower interest rate. For those with a lower credit score, your risk of defaulting is higher when you borrow money, so lenders will likely charge a higher interest rate.
Down Payment
A down payment is simply the amount of money you pay upfront for your house, but it also plays an important role in establishing your risk level as a borrower. That’s because your down payment amount determines your loan-to-value (LTV) ratio.
Your LTV ratio compares the amount of your mortgage loan to the overall value of the home you wish to purchase. Lenders use the loan-to-value ratio to assess the risk of lending you money, as a higher loan-to-value ratio creates a riskier situation for the lender. The more you invest as a down payment toward the cost of your home, the less you’ll need to borrow, driving down your LTV ratio. This makes you a lower-risk borrower, giving you access to lower interest rates. For homebuyers who pay below 20% for their down payment, their interest rates may be higher as a result.The only exception to this happens when borrowers use VA loans or other government-backed loans. Even if you can’t afford a down payment on a VA loan, you will likely still have access to a relatively low interest rate compared to conventional mortgages.
Loan Type
The type of loan you pursue will partially determine mortgage rates. For example, a fixed-rate loan locks in the same interest rate for the life of the loan, no matter where the market goes. Fixed-rate mortgages tend to start with higher interest rates since the lender has to account for potential changes in the market. However, this is a benefit for borrowers, as they will know exactly what to expect from their monthly payment and can budget accordingly. The majority of LGBTQ+ borrowers - about 83% - select this option.
Adjustable-rate mortgages flex with the market after a few years, and they typically offer lower introductory rates. This option is good for borrowers who do not intend to stay in their homes for long or have the funds to save up for the higher payments down the line.
The loan product you choose will also impact the mortgage rate you qualify for. For example, government-backed VA loans for veterans, active-duty service members, and surviving spouses offer very low mortgage rates to support a lower monthly payment. Jumbo loans, on the other hand, usually have much higher mortgage rates because they involve lending much larger sums of money. The rates on a conventional loan will fall somewhere in between.
Additionally, loans for investment property generally have higher rates because they are considered riskier for lenders. If a business owner runs into trouble with their company, they may choose to let go of the property and file for bankruptcy, while residential borrowers will attempt to keep their home.
Loan Term
Your loan term may also play a role in your overall interest rate. Shorter loan terms yield profits more quickly for the lender, motivating them to offer better interest rates for shorter loans, like a 15-year mortgage. For a 30-year mortgage, it takes longer for the lender to make their money back, so they will charge a higher interest rate to compensate for the longer term and higher risk.
Discount Points and Lender Credits
Discount points and lender credits can also impact your mortgage rate when you’re negotiating your loan amount and loan terms. Discount mortgage points are earned by paying more for closing costs or down payments, offsetting the amount of your loan and reducing risk for mortgage lenders. On the other hand, lender credits are paid by the lender to reduce closing costs at the time of sale.
In exchange for this assistance, the borrower may need to agree to a higher interest rate. The first option is ideal for borrowers who can afford to pay more upfront and want to lower their monthly payments, while the second option is better for those who cannot afford as much on the initial investment. When negotiating with your lender, inquire about any other interest rate trade-offs that may be available to you to lower your monthly rate.
Other Factors Influencing Mortgage Rates
A few other factors can influence mortgage rates when you are in the market for a home. These last considerations are harder to predict long-term, so analyzing their impact in real-time is the best way to determine how they will affect your mortgage’s interest rate.
Housing Market Conditions
The local housing market where you’re buying your house will affect how your mortgage rates are determined. For example, if there is low demand for housing in your area, mortgage rates may drop to entice more buyers into the market. Mortgage rates are also impacted by trends in housing prices in a specific market. Climbing prices tend to decrease demand, which can send mortgage rates down as well.
Global Events
While it may seem like a stretch, events on the other side of the world can affect your mortgage interest rate. Geopolitical risks and economic instability can impact all financial markets, including the real estate sector. Aside from major wars and recessions, other global factors will likely have only a small impact on the mortgage rates you qualify for.
For example, the Covid-19 pandemic had a significant impact on mortgage rates. Borrowers were able to enjoy some of the lowest rates since the 1970s. The Federal Reserve pushed rates down to below 3%, spurring a spate of homebuying. However, in 2022, rates shot up to the highest levels since 2002 because of major inflation, and they have remained high since.
How Mortgage Lenders Set Rates
Based on the factors mentioned above, lenders must respond to both the market and the borrower to set their mortgage rates. Things like time of year, housing market conditions, and the specific borrower applying for a loan can all affect mortgage rates from lender to lender. Here is a quick glimpse into the process mortgage lenders use to set their interest rates for potential homebuyers.
Setting a Base Rate Based on Market Conditions
A mortgage lender typically sets a base rate based on the conditions of the market in which the borrower is looking for a home. For example, the base rate in Miami won’t be the same as the base rate for a lender in rural Idaho. While this base rate won’t determine your mortgage rate entirely, it will have an effect when paired with your personal finance situation.
Adjusting the Rate Based on Borrower's Profile
Using that base rate, the mortgage lender will then evaluate each individual borrower based on personal factors. These calculations are to determine your risk profile, or the possibility that you will default on your loan. Having a better profile means that you are less likely to default, and therefore, the lender will get their money back with interest.
They will take into account your debt-to-income ratio (DTI), your credit score, your gross monthly income, the size of the intended down payment, your LTV ratio, and many other factors to adjust their mortgage rate offering from the base rate.
Once the lender has assessed the borrower’s unique risk, they will establish a mortgage loan interest rate based on their findings.
Unfortunately, this process is not always exactly fair. Despite the Fair Housing Act requiring that people of protected classes be given the same opportunities as their peers, discrimination does unfortunately still happen.
For example, a study found that same-sex couples are 73% more likely to be denied a loan, and when they are approved, they may face higher interest rates. LGBTQ+ couples paid, on average, approximately 0.02% to 0.2% more in interest and fees. While this may not seem like much, it adds up significantly over time.
The Federal Reserve of Minneapolis examined mortgage denials and found that borrowers of color are significantly more likely to be denied loans. Adjusting for different factors did not remove the racial disparities, meaning that there is a significant issue of discrimination. Black borrowers also deal with higher interest rates when they are approved, even when they have the same financial profile as their peers.
Working with a mortgage broker like Pride Lending can help ensure that you have access to the best possible rates and have your application filled out exactly as lenders expect. We will walk you through the process to ensure a smooth borrowing experience. Our goal is to serve as your advocate and make sure that you have everything you need to succeed.
Considering Operational Costs and Profit Margins
Another element that will impact the interest rates of a lender’s mortgage loans is profitability. Lenders have operational costs that must be covered, primarily through interest payments from borrowers. The lender will analyze what interest rate is needed to result in acceptable profit margins for the business.
Tips for Getting the Best Mortgage Rate
Pursuing the lowest possible mortgage interest rate is a great way to make your home more affordable. A better mortgage rate will ensure you have a lower monthly payment and a lower total loan amount. In the end, a percentage point or two could save you tens of thousands of dollars over the course of your loan.
Here are some strategies to help you get a lower interest rate.
Improve Your Credit Score
Your credit score tells the lender how reliable you are at paying back debts. If you have a great credit score and make on-time payments on all your credit accounts, the lender will see you as less risky and offer more competitive mortgage interest rates. In general, those with a score above 720 will have the best possible rates and may not have to put as much down as those with poor scores. This can pose a significant challenge for some borrowers, especially those who come from marginalized communities.
Both LGBTQ+ and BIPOC communities tend to have lower scores due to higher debt and lower salaries; for example, Native American borrowers have scores of approximately 612, which is very low compared to the national average of 709. LGBTQ+ borrowers are twice as likely as their counterparts to “poor” or “very poor” FICO scores, which can make it a challenge to secure financing.
However, this doesn’t mean you’ll never be able to purchase a home: it’s possible to raise your score through careful financing, debt counseling, and smart utilization of your existing credit. If you’re wondering how to improve your credit score, the basic principles include diversifying your credit, having a long and consistent payment history, avoiding hard inquiries, and keeping your utilization ratio low.
Save for a Larger Down Payment
As mentioned before, down payments can help determine loan rates. With a bigger down payment, the loan-to-value ratio drops, so your risk as a borrower decreases. The less risk involved for the lender, the more likely they are to provide lower interest rates for your mortgage. If possible, start saving for a larger down payment as soon as possible. This will help you access more competitive rates when you’re looking to buy a home.
Most down payment requirements for conventional loans start at 3% for first-time buyers or 5% for repeat buyers. With an FHA loan, your down payment requirement is determined by your credit score. If you have a score between 500 and 579, you need to put 10% down, while if you have a score of 580 or higher, you only need to provide 3.5%.
USDA and VA loans do not require any money down, but providing a percentage upfront will help you secure better rates anyway.
In general, you should try to set aside 20% of the home’s purchase price for a down payment. This will eliminate private mortgage insurance and help you secure the best interest rates, as lenders will be less concerned about you defaulting. However, this can be a major challenge, especially for LGBTQ+ and BIPOC borrowers who may have higher debt and less savings.
Pride Lending will match you to local down payment assistance programs, as well as search for state and national programs that meet your needs. These programs may be grants, which do not need to be paid back, or they may be loans with zero interest rate that only must be repaid when you move. These programs can help you reach that 20%, which will serve you well in the future.
Shop Around and Compare Offers from Multiple Lenders
Mortgage lenders do not exist in a vacuum. They must compete with other lending institutions to entice borrowers to work with them. That means you can take advantage of this competition to find the best rates possible. Compare rates from various lenders to see which bank has the best offer. In some cases, two lenders may have matching policies, but one might offer a lower interest rate than normal to acquire your business.
Our team works with a variety of lenders who offer different programs, including FHA-approved lenders and VA lenders. We’ll take a look at your financial situation and match you to loan options that best meet your needs. Most importantly, we serve as your advocate and ally throughout the process, ensuring that you have everything you need to succeed.
Consider Timing the Market (With Caution)
Mortgage rates for conventional loans and other mortgage products can fluctuate throughout the year. If you buy during the right season, you could find a better rate on the market if demand is particularly low, such as in the winter months. Additionally, you can time your purchase based on the overall condition of the local market. However, use caution when employing this strategy, as financial markets can be unpredictable, and you could be at the mercy of an expiring lease that will limit your options for timing the market well.
Get Pre-Approved for a Mortgage
Pre-approval can be a great way to lock in a low interest rate. Some lenders may offer the option of locking in a certain rate when you complete the pre-approval process. However, you will have a limited time to close on a home before that rate expires. Pre-approval can also help you move faster to close the transaction, giving you an edge over other buyers.
Conclusion
Whether you’re applying for conventional loans, FHA loans, or jumbo loans, your monthly payment and total loan amount will be affected by your mortgage rate, and many factors impact how that rate is determined by your lender. The current federal funds rate, the state of the greater economy, the profit margins of the lender, the credit score and down payment of the borrower, and even the type of loan all explain why mortgage rates vary so much.
Pride Lending is a company committed to helping all borrowers secure the home of their dreams, regardless of their identity or personal background. Our team is composed of allies and members of marginalized communities, including LGBTQ+ and BIPOC mortgage professionals, who are familiar with the challenges that these communities face.
We believe that everyone deserves a beautiful place to live, regardless of their race, national identity, sex, gender identity, sexuality, or age. As such, we work hard to advocate for our clients and help them secure the best possible loan products.
When you have questions about how market factors and borrower-specific data factors affect your mortgage rate, Pride Lending can provide the answers. Call us today at 725-231-0192 to discuss your desired loan term, down payment, or personal finance questions.
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