How Mortgage Rates are Determined - A Guide for Borrowers
Updated: Jan 1
Navigating the world of mortgages can be overwhelming, especially for first-time homebuyers. With numerous options, terms, and processes, it's essential to have a solid understanding of the mortgage market to make informed decisions. In this blog post, we'll explore the basics of the mortgage market, providing a comprehensive guide for borrowers looking to secure the best financing options for their new homes. Join us as we break down key concepts and provide insights to help you on your journey to homeownership.
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Understanding Mortgages
When you want to buy something but don't have enough cash on hand, financing or taking out a loan is an option. This allows you to make payments over time while enjoying the benefits of the asset you purchased. One example of this is auto financing or car payments.
A mortgage, on the other hand, is a type of financing that allows you to purchase a home. Similar to an auto loan, a mortgage gives you legal ownership of the underlying asset, which is your home. However, if you fail to make your payments, the lender can take back or "repossess" your home, which serves as the collateral. The process of foreclosure can be complex and time-consuming, but it allows the lender to recoup their investment.
So why do lenders offer mortgages? Lenders make money by charging interest on the loans they provide. The interest is an additional amount of money beyond the amount borrowed that allows the lender to profit from the transaction. In the case of mortgages, interest rates can be quite complex. In this series of articles, we will delve into this topic and help you understand everything you need to know about mortgage rates.
It's important to note that there are some exceptions to the interest rate rule. For example, some car dealerships may offer 0% financing as a way to sell more cars. However, it's important to understand that a 0% interest rate doesn't necessarily mean you're not paying anything extra. In some cases, you may be giving up other incentives, such as a cash back option, in exchange for the 0% rate.
In summary, a mortgage is a type of loan that allows you to purchase a home by making payments over time. The lender profits by charging interest on the loan, and the home serves as collateral in case of default. Stay tuned for more articles in this series to learn more about mortgage rates and how they work.
Understanding the Basic Parts of a Mortgage
In Part 1 of our Mortgage Rates 101 series, we talked about what a mortgage is and how lenders profit from offering mortgages. In Part 2, we'll delve into the basic parts of a mortgage and how they affect your overall cost of financing.
When you take out a mortgage, you'll be charged an interest rate on the principal balance of the loan. This is what most people refer to as the "mortgage rate," but it's actually only part of the equation. The interest rate is also known as the "note rate" and is the rate applied to the loan amount.
However, there are other costs involved in a mortgage beyond the note rate. These upfront costs, charged by various parties like lenders, appraisers, and insurance companies, add to the overall cost of financing. Because of this, the actual or "effective" rate you pay on your money may differ slightly from the note rate.
To help borrowers understand the true cost of financing, the Truth in Lending Act requires lenders to disclose the Annual Percentage Rate (APR), which attempts to convey the effective rate. However, not all lenders calculate APR in the same way, so it's important to understand the tradeoffs between upfront costs and payments over time.
One way to lower your interest rate is by paying extra upfront in exchange for what's known as "points" or "discount points." This can be a good option if you plan on having the mortgage for a long time and wouldn't be earning a high return on that extra cash by investing it elsewhere. However, if you can earn a higher return on that cash, it may make more sense to minimize your upfront costs and invest the extra cash.
Ultimately, the choice between paying upfront or over time depends on your individual situation and financial goals. Your lender should be able to show you the difference between the options in terms of the number of months it will take to break even on the additional upfront cost.
In addition to understanding the note rate and upfront costs, it's important to understand the concept of principal. This refers to the current balance of the loan/mortgage, which is the amount borrowed to buy the home minus any upfront payment or down payment made. As you make payments, the amount you owe decreases, and when it reaches zero, you own the home outright.
It's also important to note the difference between the principal balance and the payoff balance. The payoff balance may be slightly higher than the principal balance due to interest charged during the previous month. If you pay off your loan in the middle of any given month, the lender will add the number of days between the 1st of the month and the payoff date to the payoff balance.
In summary, a mortgage has several basic parts, including the note rate, upfront costs, principal balance, and payoff balance. Understanding these parts is essential to understanding the overall cost of financing and making informed decisions about your mortgage. In Part 3 of our Mortgage Rates 101 series, we'll delve further into the concept of interest rates and how they affect your mortgage.
Understanding Annual Percentage Rate (APR)
In Part 2 of our Mortgage Rates 101 series, we discussed the basic parts of a mortgage, including the note rate and upfront costs. In Part 3, we'll delve into Annual Percentage Rate (APR) and how it attempts to factor in upfront costs to deliver a more accurate "cost of financing."
APR is a measurement designed to convey the true cost of financing by factoring in upfront costs associated with the mortgage. These costs, known as prepaid finance charges (PFCs), are charges that are only paid to obtain the mortgage and are not tied to a tangible service. While PFCs are not necessarily good or bad, they can significantly affect the overall cost of financing.
Lenders are required by law to disclose APR, but the calculation of APR is not straightforward. Regulators leave it up to lenders to determine the APR, which can lead to variations in how APR is calculated. This means that a slightly lower APR from one lender may not necessarily be a better deal than a higher APR from another lender.
To accurately compare APRs between lenders, it's important to understand the specific upfront cost assumptions that are being used. This means looking at the line-by-line breakdown of upfront costs associated with each lender's APR.
It's important to keep in mind that APR is not a perfect measurement, as it relies on human input and variables that can be manipulated to a certain extent. Despite this, APR is still a useful tool for comparing mortgages and understanding the overall cost of financing.
In summary, APR attempts to factor in upfront costs to deliver a more accurate "cost of financing" than the note rate alone. However, because APR relies on lender input and calculations, it's important to compare the specific upfront cost assumptions between lenders to accurately compare APRs. In Part 4 of our Mortgage Rates 101 series, we'll delve further into the factors that affect your interest rate and how you can get the best rate possible.
Understanding How Mortgage Rates are Determined
Mortgage rates are not arbitrary; they are driven by investor demand. Mortgage investments are comparable to bonds, which offer a lower risk and stable return, and therefore, are attractive to investors. However, mortgages are considered riskier than "guaranteed" bonds, like US Treasuries, due to unpredictable consumer behavior. Investors expect higher rates of return for riskier scenarios such as lower credit scores.
At its most fundamental level, mortgages resemble bonds, which are fixed-income investments where an investor provides a lump sum and receives a return on the investment over time. There are different types of bonds in the bond market, and those that are similar tend to move in the same direction based on investor demand. Consequently, changes in the bond market generally affect mortgage rates.
Lenders make further rate adjustments based on credit scores, down-payment amounts, and other risk factors, but these changes are relatively stable. Day-to-day fluctuations in an individual rate quote are typically determined by changes in the bond market, unless there are significant changes in credit scores or down-payment amounts.
Investor demand is vital to mortgage rates. A lender's interest rate offers a competitive rate of return without significant risk compared to other similar investments. Mortgages are most similar to bonds, which are known as "fixed-income" investments, where the investor provides a lump sum upfront in exchange for a fixed schedule of payments over time.
Unlike most fixed-income investments, the borrower in the case of mortgages is a consumer. Consumers can choose to refinance or sell, which can cut off the investor's monthly payments and make them lose money. This is why investors often pay a premium for the right to collect monthly payments on a mortgage.
In most cases, mortgage transactions do not involve just one investor buying one mortgage. Investors often buy multiple mortgages to increase the likelihood of having mortgages remaining, even if a few of them are paid back early. Alternatively, investors may purchase a chunk of a similar portfolio of mortgages, which is known as securitization.
In conclusion, mortgage rates depend on investor demand, and investors perceive mortgages as similar to bonds, which offer a lower risk and stable return. Although mortgages are riskier than guaranteed bonds, lenders' interest rates are competitive with similar investments. Changes in the bond market determine the day-to-day fluctuations of mortgage rates, and lenders make additional adjustments based on credit scores, down-payment amounts, and other risk factors.
What Causes Mortgage Rates to Change?
Mortgage rates are constantly changing and can shift multiple times a day. The combination of upfront cost and interest rate determines mortgage rates. The factors driving these changes are complex and interdependent. Investors offer loans to earn interest, and this desire for profit leads to fluctuations in mortgage rates. The bond market, which includes government debt, serves as a benchmark for various types of debt, including mortgages. Mortgage-backed securities (MBS) are a market for groups of loans that are sold to investors. The prices of MBS are affected by the same factors that influence the bond market and have a direct impact on mortgage rates.
Operational considerations also impact mortgage rates. Lenders use the price that investors are willing to pay for MBS as a baseline for determining the costs they must charge borrowers. Lenders' operational considerations, such as cash flow and personnel availability, also influence mortgage rates. These factors complement the market-driven prices of mortgages. Lenders may adjust rates to entice more business or to keep up with demand.
Mortgage-backed-securities are like raw materials for lenders, and individual lenders are like manufacturers. The price of MBS can move throughout the day, influencing the moment-to-moment changes in lenders' rate sheets. When investor demand increases in the bond market, MBS prices rise, and lenders may offer lower rates. If investors seek riskier investments, MBS prices may fall, causing lenders to raise rates. Ultimately, the prices of MBS dictate the rates that lenders can offer to new mortgage borrowers.
Locking Your Mortgage Rate
When applying for a mortgage, one of the most important decisions a borrower will have to make is whether to lock their interest rate or let it float. Locking the rate means agreeing on a specific interest rate with the lender, while floating means taking the risk that the rate will change between application and closing. In this post, we will explore the factors to consider when deciding whether to lock your mortgage rate.
➡️ Lock Time Frames
When a borrower and lender agree on a rate, they will also specify a date by which the mortgage must be closed and funded. Historically, the most common lock time frame was 30 days, but in recent years, 45 and 60-day lock times have become more prevalent. Other lock time frames are available, such as 10, 15, 21, and 90 days, depending on the lender. Some lenders may not allow borrowers to choose when and for how long to lock.
➡️ Cost Considerations
The longer the lock window, the higher the cost. Costs associated with the rate can take the form of changes to the rate itself or changes to the upfront cost (discount or rebate) associated with that rate. Locking the same rate for longer means that the discount cost will be higher or the rebate will be lower. The relationship between days of lock time and cost isn’t always exactly linear, so it’s important to weigh the risk and reward of various time frames.
➡️ When to Lock
There’s no one-size-fits-all answer to the question of when to lock your mortgage rate. Many variables, such as market conditions and personal financial situation, affect the decision. Generally, locking as early as possible is the safest option for borrowers, but it’s not always the most profitable option. It’s important to be prepared for the increased costs associated with an unforeseen rise in rates if you decide to forego locking.
➡️ Purchase and Refi Lock Considerations
Failing to lock your rate can have severe consequences, such as losing the earnest money deposit or the opportunity to buy the desired property. Even in the case of refinancing, failing to complete the mortgage can result in the loss of significant monthly savings or much-needed cash for any number of purposes. Therefore, it’s almost always wise to heavily consider locking as soon as the monthly payment and lock time frame make sense for your scenario.
➡️ Lock Extensions and Expirations
Some mortgages are destined to run past their initial lock time frame. In most cases, lenders can extend the lock time frame for a predetermined cost. However, if rates have moved significantly higher since you first locked, extending the lock could result in worst-case pricing, which means paying whichever is higher between the original cost of the lock time frame needed to complete the loan or the current market rate.
In summary, locking your mortgage rate is an important decision that requires careful consideration of various factors. While there is no universal answer as to when to lock, it’s almost always wise to do so as soon as the monthly payment and lock time frame make sense for your scenario. In the end, it’s better to be safe than sorry and avoid the potentially severe consequences of failing to lock your rate.
Securitization and MBS
In this section, we will explore the key concepts of securitization and Mortgage-Backed-Securities (MBS) and how they affect mortgage rates.
Key Concepts
✔ Securitization turns mortgages into bonds.
✔ It makes rates lower and allows them to follow other bonds more closely.
✔ MBS groups similar loans together and allows for risk-sharing among investors.
✔ Standardization of MBS makes it easier for investors to buy mortgages without evaluating each underlying loan.
✔ MBS prices are influenced by movement in US Treasuries prices.
✔ As MBS prices rise, it means investors are willing to pay more to obtain mortgages, which leads to a decrease in cash flow to the lender and a potential decrease in interest rates.
Understanding Securitization
✔ Securitization turns mortgages into bonds that can be sold, bought, and traded.
✔ Mortgage-Backed-Securities (MBS) are what groups of similar loans turn into in order to be sold, bought, and traded.
✔ MBS allows for risk-sharing among investors.
✔ This risk-sharing helps to keep rates lower than they otherwise would be.
✔ Standardization of MBS makes it easier for investors to buy mortgages without evaluating each underlying loan.
US Treasuries and MBS
✔ MBS prices are influenced by movement in US Treasuries prices.
✔ Investors want to buy a certain amount of bonds for certain reasons just like grocery shoppers tend to buy a certain amount of produce.
✔ As MBS prices rise, it means investors are willing to pay more to obtain mortgages.
✔ The more an investor pays, the lower a mortgage rate can be.
✔ There is an inverse relationship between price and rate.
Overview / Conclusion Key Concepts
Understand how investors, lenders, and borrowers come together to determine the final mortgage rate.
The Lifecycle of a Mortgage Rate
Mortgage rates start with the borrower. When you want to buy a home but don't have the cash to pay for it outright, you need a mortgage. This creates demand in the mortgage marketplace, which is what investors are looking for. Investors can include anyone who invests in managed funds with a "fixed-income" component, as these funds may include bonds backed by mortgages.
Most mortgages become investments through the securitization process. A government agency sets standards for loans it will insure and provides a framework for mortgage companies to evaluate loan scenarios. If a scenario meets the agency's standards, the eventual mortgage can become part of a pool of similarly eligible mortgages called Mortgage-Backed Securities (MBS). MBS carry guarantees from government agencies, protecting investors in the event of default.
The price that big investors pay for pools of mortgages is the price of a certain category of MBS, which are essentially bonds with either an explicit or implicit guarantee from the US government. The effective rate of return on MBS is influenced by the level of demand, which in turn is affected by how MBS returns look compared to US Treasuries of similar durations.
Mortgage rates tend to move a lot like US Treasuries of similar durations because investors are willing to accept cash flow uncertainty for a higher rate of return. The gap between a 10-year US Treasury yield and the average top-tier 30-year fixed mortgage rate quote has maintained a range of 1.55-2.0% since September 2012, which is the foundation of the first several percentage points of any mortgage interest rate.
Lender Variables
Lenders vary with respect to what they can offer in terms of rates, which can be affected by profit margins, number of employees, advertising/legal costs, and other factors affecting overall efficiency. While a lower rate may seem like a better deal, there may be a higher risk that something unexpected happens during the course of your transaction. Some mortgage companies may quote lower fees, but it's important to keep in mind that there are other fees associated with a mortgage.
FAQ's
How do they determine your mortgage rate?
Mortgage rates are determined by a variety of factors, both macroeconomic and personal. Macroeconomic factors include the state of the economy, inflation rates, and the policies of the Federal Reserve. Personal factors include your credit score, down payment size, loan-to-value ratio, and the type of loan you choose. Lenders assess these factors to determine the risk associated with lending to you, which in turn influences the mortgage rate you're offered.
Are mortgage rates based on the 10-year Treasury?
While mortgage rates often move in the same direction as the 10-year Treasury yield, they are not directly based on it. Mortgage rates are more directly influenced by the rates on mortgage-backed securities (MBS), which are bonds backed by mortgage loans. However, the 10-year Treasury yield is a key benchmark for the overall direction of interest rates, and changes in this yield can influence the rates on MBS and, by extension, mortgage rates.
What are the 3 main factors that affect interest rates?
The three main factors that affect interest rates are:
The Federal Reserve's Monetary Policy: The Federal Reserve can influence interest rates by adjusting the federal funds rate, which is the rate at which banks lend to each other overnight. Changes in this rate can ripple through the economy and affect mortgage rates.
Inflation: Higher inflation can lead to higher interest rates as lenders demand higher returns to compensate for the loss of purchasing power of the money they will be repaid in the future.
Economic Growth: Strong economic growth can lead to higher interest rates as increased demand for credit can drive up the cost of borrowing.
Do mortgage rates vary by lender?
Yes, mortgage rates can vary by lender. Each lender has its own method for assessing risk and setting interest rates, and these methods can result in different rates for the same borrower. Additionally, lenders have different business models and cost structures, which can also influence the rates they offer. This is why it's important for borrowers to shop around and compare rates from multiple lenders before choosing a mortgage.
Philip Bennett
Philip is the owner and Licensed Mortgage Broker at Bennett Capital Partners. He earned his degree in Accounting and Finance from Binghamton University and holds a Master's Degree in Finance from NOVA Southeastern University. With more than 20 years of experience, Philip has been a leader in the mortgage industry. He has personally originated over $2 billion in residential and commercial mortgages.
Learn more about Philip Bennett's background and experience on our Founder's page. Whether you're a first-time homebuyer or a seasoned real estate investor, our team is here to help you achieve your real estate goals. Don't wait any longer, contact us today and let us help you find the right mortgage for your needs.
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