It’s a message we’ve gotten very used to hearing over the last few years: Rates are near historical lows. Lock your rate in now because they won’t be this low forever.
The exact words change, but the message always remains the same. If you’re in the market for a mortgage, you may be wondering how rates are set. Otherwise, it just sounds like mortgage companies are throwing darts at a board to come up with a number. I can assure you that darts aren’t involved.
Mortgage rate changes have to do with movement in the bond market.
Mortgages and the Bond Market
When you close on a mortgage, very rarely does a single lender hold your loan for 30 years anymore. If lenders did do this, they would have to loan you the money and then wait a couple of decades to get enough money to make a mortgage loan to someone else. The cash flow issue means that not many people would own homes.
To get around this, most loans are packaged together in something called a mortgage-backed security and sold to investors in the bond market. A single mortgage-backed security typically contains many loans that are grouped together based on specific loan characteristics.
As an example, a mortgage-backed security might be made up of 10 Freddie Mac loans with a term of 15 years and credit scores of 720 or more. You could also have 10 FHA loans with credit scores of at least 640 and a 30-year term – or any number of other combinations.
Just because your loan is sold on the bond market doesn’t mean your relationship with your lender necessarily ends. Many lenders (including Quicken Loans) service the majority of their loans, collecting monthly payments for the bondholder.
Bondholders also typically have some assurance that the bonds will pay off because they’re insured by government-sponsored enterprises like Fannie Mae and Freddie Mac. If the loan is through the FHA or VA, it’s insured by the government agencies themselves. These entities have strict standards for the types of loans they will insure. This is where the standards for minimum down payments and credit scores, among others, come from.
Mortgage-Backed Securities and Mortgage Rates
Now that you know how individual mortgages are put together to make up a bond, how does that affect rates? Mortgage rates are directly affected by the purchase and sale of mortgage bonds. The more mortgage bonds that are being sold, the lower the yield has to be in order to get someone to buy. When there’s less demand, there are higher yields. In general, the lower the yield on mortgage bonds, the lower your rate.
It’s therefore a case of supply and demand. But what drives the demand for bonds?
Bonds Are Safe
There’s a lot going on in the world right now. Britain has exited the European Union. There seems to be an oversupply of oil, causing profits in that sector to fall. And while a strong U.S. dollar might be thought of as a good thing, it lowers the value of foreign currency in comparison, hurting the bottom line and the stock of companies that rely on exports.
In an environment with this much uncertainty, investors look for a safe investment outside of the stock market and oil futures with which to grow their money. The flight to the safety of the bond market sells more bonds, including mortgage bonds. As a result, you’ll see a drop in yields that leads to a drop in rates.
When times are good – for instance, when employment and spending are on the rise – people leave the bond market for the higher returns of stocks when that market regains its footing. Mortgage bonds are sold, and yields and rates rise.
Sometimes the government gets involved in the bond markets in order to influence the cost of borrowing money, which has an impact on inflation.
The government actually likes a little bit of control on inflation because it encourages people to buy now before the price goes up. On the other hand, if inflation gets too high, it substantially decreases the value of your money relative to other currencies around the world.
The Federal Reserve is the central bank of the U.S., and it’s responsible for controlling the money supply and the interest rate at which banks borrow money.
One of the ways the Federal Reserve can stimulate the economy is by driving the cost of borrowing down. It can do this by generally making it cheaper for banks to borrow money, as it did a couple years ago, pushing rates at which lenders borrow money to essentially zero. In turn, lenders pass some of that savings on to borrowers.
However, you can only cut rates so much. Occasionally, the Fed looks for other ways to give the economy a helping hand. Where might it look?
Housing is a huge economic driver. How big? One study by the National Association of Home Builders shows that the average buyer of a single-family existing home spends $4,284 on furniture and appliances alone within the first year of ownership. New home buyers will spend upward of $8,000 in these categories. That’s a lot of money flowing through the economy.
One of the ways the Fed can encourage people to buy houses is to lower mortgage rates. It does this by buying enough mortgage bonds to drive down rates.
When the Fed thinks that the economy is strong enough to withstand an interest rate increase, it will sell off the bonds and raise the rate at which banks borrow money. This pushes interest rates higher but also encourages investment at the same time.
Everything we’ve talked about so far has dealt with how baseline rates are set. While these rates give you a good idea for market trends and the general direction rates are headed, the baseline rate really doesn’t have a lot to do with your rate. Instead, it serves as a starting point.
The rate individual borrowers get really depends on several factors, including income, property type, assets and credit. In general, the bigger the down payment you make, the better the rate you’re going to get. There’s less risk involved for the lender because the loan is smaller relative to the property value.
Because the rate is so personalized, it’s difficult to advertise rates. When lenders do advertise rates, be mindful of two things: the APR and the assumptions they’re using.
APR stands for annual percentage rate and represents the actual cost of getting the loan. When you’re comparing rates, you’ll see one rate that’s a bit lower and another rate that’s higher next to it.
The first rate is the interest rate. The rate next to it is the APR, which factors in things like mortgage insurance, origination cost and any prepaid interest points. The bigger the difference between the interest rate and the APR, the higher the lender’s fees and costs. It’s something to be aware of.
You should also be aware of the circumstances those rates are based on. Because everyone’s situation is different, lenders have to have a scenario on which to base the rate. If you’re shopping, find out what they’re basing the rate on, which will give you a point of comparison.
Lenders will often use assumptions about the borrower, such as a certain credit score, and use a certain loan-to-value (LTV) ratio. LTV has to do with the size of the down payment or the amount of equity you have in your home. Finally, it might specify that a certain number of prepaid interest points are built into that rate.
Mortgage rates can be confusing, but it’s easier if you know how to shop.
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