How are mortgage interest rates set by lenders?
When developing a home buying budget, it is important to understand that there are a variety of factors to consider beyond a property’s list price. Mortgage interest rates are the main ones.
Interest rates have a major impact on your monthly mortgage payment and for many buyers can be a deciding factor when it comes to home affordability. It is therefore important to understand how mortgage rates are determined and the factors that contribute to the rate you are offered.
What determines mortgage rates?
Various factors affect mortgage interest rates and generally fall into two main categories: current market or economic conditions and your personal financial profile as an individual.
Some examples of market conditions that can impact mortgage interest rates include inflation and Federal Reserve actions. Although, things like your credit score, down payment, and loan-to-value (LTV) ratio are some of the personal factors that play a role in the interest rate you are offered.
Personal factors that influence your interest rate
As lenders assess your mortgage application and therefore your ability to repay a mortgage, they take a hard look at your finances, looking at things like your bill paying history, the down payment you make on buying a home and your current level of debt.
1. Your credit score
Your credit score is one of the most critical elements of a loan application. “A credit score is a tool that helps assess historical ability and willingness to repay debt. The lower the score, the greater the risk of delay or default,” says Mike Hardy, managing partner at national lender Churchill Mortgage.
For this reason, it allows lenders to immediately get an idea of your responsibility for your finances and debts, and therefore the risk you represent in terms of lending. For these reasons, credit scores, which range from 300 to 850, play an important role in the interest rate you are offered.
“The higher your credit score, the better your chances of getting approved at a favorable interest rate,” says Rob Cook, vice president, Discover Home Loans.
Having a strong credit history, which includes a long track record of consistently paying bills on time and maintaining low balances on lines of credit, boosts your credit score. This is usually the type of profile potential lenders like to see.
For example, your FICO score, which is one of many credit scoring models, is made up of the following basic components: payment history (35%); Amounts due (30%); Length of credit history (15%); New credit applications (10%); and credit composition (10%).
Before applying for a mortgage, it’s a good idea to check your credit score and do what you can to improve it if there are any areas of concern. If you still have a little time before you need to apply for a mortgage, actively work to increase your score.
2. Your LTV ratio
Another consideration for lenders when developing interest rate quotes is what is known as the applicant’s LTV. It is essentially a comparison between the loan amount you are applying for and the value of the property you hope to buy.
Applicants who have a larger down payment for their home purchase – which reduces the amount they need to borrow from a lender – have what is called a lower loan LTV ratio. This is a good thing from the lender’s point of view.
“Loan to value metrics along with credit score and other metrics play a big role in determining the rates you qualify for,” Cook explains. “Banks know that a ‘good’ combined loan-to-value ratio, typically 80% or less, means a borrower is less likely to default on a loan.”
To calculate LTV, simply divide the loan amount sought by the appraised value of the home, says Brandon Snow, executive director of direct-to-consumer programming at Ally Bank. For example, if you apply for a mortgage of $160,000 and the house you want to buy is valued at $200,000, your LTV is 80%. In this scenario, you would borrow 80% of the home’s value.
3. Your deposit
The amount of down payment on your new home also plays an important role in your interest rate. Generally, the larger the down payment you make, the lower your mortgage interest rate is likely to be. Indeed, lenders consider that applicants who have a larger down payment present a lower risk.
“The larger your down payment, the lower your loan-to-value ratio, which affects your eligibility and available rates,” Cook says.
Although a 20% down payment isn’t always required to buy a home, having this amount can help you get a much more competitive interest rate. It should also be noted that applicants who do not have a 20% down payment may also be required by lenders to obtain private mortgage insurance (PMI), a cost which is added to your monthly mortgage payments. PMI is insurance designed to protect lenders in the event of borrower default.
Market conditions that affect interest rates
There are also factors affecting mortgage interest rate offers that have little to do with you, your credit score, your down payment or any other part of your financial profile. These variables are beyond your control.
1. The Federal Reserve
Although the Federal Reserve does not specifically set mortgage interest rates, its actions play a role in the rates offered by lenders.
In a very simplified sense, what the Federal Reserve does is adjust what is called the federal funds rate or benchmark rate, which is the short-term lending rate that banks charge each other. The federal funds rate is adjusted based on changing economic conditions. And when changed, it impacts what consumers ultimately pay to borrow money.
“When the federal funds rate goes up, it becomes more expensive for banks to borrow from other banks. These higher costs can be passed on to consumers in the form of higher interest rates on lines of credit, auto loans and, to some extent, mortgages,” Cook explains.
Market conditions also include inflation, which impacts house prices and mortgage interest rates. “Inflation reduces the value of the dollar, which means it costs more to buy things. In times of high inflation, mortgage interest rates tend to rise,” says Snow.
Interest rates go up under such conditions because lenders also need to make money, adds Jeffrey Taylor, board member of the Mortgage Bankers Association (MBA). “As the purchasing power of the dollar erodes, mortgage lenders must raise interest rates to ensure that their interest is earning a profit, or at this point, breaking even.”
And here too, the Federal Reserve plays a role in your mortgage interest rate. This is because when inflation rises too sharply, the Federal Reserve will step in and try to bring the situation under control by raising benchmark interest rates, which will make it more expensive to borrow and spend money.
“The Fed is adjusting its benchmark rate to stimulate economic growth, by lowering the benchmark rate,” Snow continues. “Or [it will seek to slow] economic growth if inflation rises too quickly, by raising the reference rate, as we have seen recently.
3. Economic conditions
Beyond the issues already mentioned, there are a handful of other economic and market realities that can influence the mortgage interest rates available at any given time, Taylor says.
Some of these additional factors include the rate of economic growth, the bond market, and general housing market conditions, i.e. the available supply of homes for sale and the demand for buying those homes.
“Each on its own has an impact on the housing market, and together, if one or more are down, it can have a compounded effect,” says Taylor.
Does everyone get the same rates?
Because there are so many different factors involved in crafting mortgage interest rate offers for individual applicants, not everyone receives the same offer. For this reason, it’s important as a consumer to shop around with multiple lenders to ensure you’re accessing the most competitive rate possible, as well as improving your own financial health if necessary.
“As a consumer, you have the right to choose the best loan for you. Shopping around is key to making an informed decision about which lender, loan type and rate is best for you,” says Valerie Saunders, Board Member of the National Association of Mortgage Brokers. “Don’t just look at one option.”
Is it possible to estimate your interest rate?
Information on current interest rates is widely available online. Often, you can go directly to a lender’s website, such as Bank of America or Discover Home Loans, for current mortgage interest rates, which can help you estimate what might be on offer.
There are also mortgage payment calculators, also available online, that include interest rates in their calculations once you provide some basic information, such as down payment and home price. When you get into home shopping, it’s a good idea to do your research and find out what your interest rate and mortgage payment might be.
You might even consider getting pre-approved for a mortgage from various lenders to see what rates might be available to you.
The take-out sale
Mortgage interest rates can make a big difference in your ability to buy your dream home. And often times it can be confusing trying to figure out how lenders are offering the rates you are being offered.
Although the market conditions that affect interest rates are beyond your control, there are many aspects of your personal financial situation that you can focus on and improve to increase your chances of being offered an interest rate. competitive interest.