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How Mortgage Rates are Determined

Thinking about buying a home? You’ll need to narrow down the neighborhood, the size and style of the space, the price and the down payment. You’ll also want to consider mortgage interest rates, which play a big role in whether or not the time is right to buy a house at all. 

Out of the variables listed above, the mortgage rate is the one thing that can change from day-to-day. Even if you bought a house on the same day as a best friend, your mortgage rates could be very different. Locking in a rate on a 30-year loan is probably the most nerve-wracking part of the process, so it’s critical to know how mortgage rates are calculated. 

There are many factors affecting mortgage rates. Some are out of your control, but others can be impacted by decisions made before you start the homebuying process. Let’s start there.

Things you can control

Mortgage rates are set based on how risky the lender determines it will be to lend you money. The riskier the loan, the higher the rate. Before getting offered a rate, your lender will assess how likely you are to fall behind on payments, and how much money they’ll lose if you stop making payments altogether. Here are just some of the rocks they’ll overturn before making that call.

Credit scores

The most important thing a lender considers is your credit score — which is probably the clearest benchmark of the risk you pose to the lender. Scores are derived using many points of data, grouped into five categories. They are:

  • Payment history: Don’t be late on credit card payments or utility bills. It could come back to haunt you! Accounts for 35%

  • The amount owed: The amount you owe versus your available credit plays a big factor. Another reason to pay off credit cards as quickly as possible. Accounts for 30%

  • Length of credit history: Opening accounts to establish credit is smart, but you need to use that credit and repay it on time. The longer you’ve had an account, the better. Accounts for 15%

  • Mix of credit: Lenders look at account types, too, like revolving credit cards and installment accounts, which are structured differently. Accounts for 10%

  • New credit: Offered a retail charge account to get a quick discount at checkout? Skip it. Each time a bank pulls a credit inquiry, it impacts your score. Accounts for 10%

  • What’s not included: Personal or demographic information such as age, race, address, marital status, income and employment don’t affect the score.

The higher the credit score, the less risky the borrower is.

  • If credit scores are under 620, something in your history says you might be a risk. You’ll still be able to buy a home, but interest rates will be high and you won’t have as many loan products to choose from. Some may even require mortgage insurance.

  • Borrowers with credit scores from 621 to 699 fare a little better. Mortgage interest rates may be lower, but you’ll still be considered risky. And you may have trouble getting a jumbo loan or financing for a vacation home.

  • Things start opening up once you achieve a credit score from 700 to 740. You’ll be offered the lowest mortgage rates and have your pick of the best loan products.

Job histories

Before a friend or relative lends you money they’ll probably do a quick calculation about whether or not you’ll pay them back. The same is true for a mortgage lender, though it takes a little longer. 

To convince a lender that you’ll make your mortgage payments on time, you’ll need a steady income. But because no one has a crystal ball, and future employment is never guaranteed, the lender examines your employment history. The longer you’ve been gainfully employed — and the fewer gaps seen between jobs — the better your chance of securing a low interest rate on your mortgage or refinance. 

Loan-to-value ratios

Lenders also use a loan-to-value (LTV) ratio to determine how much risk they’re willing to take on. In the mortgage world, the LTV compares the total loan amount with the market value of the home you’re looking to buy or refinance.

Let’s say you saved up $20,000 towards the purchase of a $100,000 house. You’d need to take out a loan for the other $80,000. The lender would calculate the loan-to-value ratio at 80%. If you needed to borrow more, it would bump up the LTV and increase the risk. LTVs higher than 80% may result in a higher mortgage rate, especially if you have a lower credit score. The lesson here is to start saving as early as possible to keep your LTV below 80%.

Loan type

Always keep in mind that the low interest rates advertised online meant to lure customers in. Your rate will vary, especially taking into account the type of loan you’ll need. Loans on manufactured homes, condos, second homes and investment properties command higher mortgage rates because they are deemed riskier. Likewise, cash out refinances and adjustable-rate mortgages will come with higher rates.

Things you can’t control

Some of what goes into determining a mortgage rate is outside of your control. Here’s a quick look at what else goes into determining a rate.

The Fed and the financial market

The Federal Reserve, which raises and lowers short-term interest rates in the economy, doesn’t set mortgage rates, but it does influence them. Although entirely independent, interest and mortgage rates usually move in the same direction, just like the stock market. That’s why you need to consider what’s happening in the economy when applying for a mortgage. Here’s what to look out for: 

  • Mortgage rates rise when the economy is taking off, with higher consumer confidence and low unemployment. 

  • Mortgage rates drop when the economy slows, when consumer confidence reverses and more people start filing for unemployment.

Inflation’s impact

You may ask why inflation affects mortgage rates, and the answer is, “inflation affects everything.” As inflation rises, you pay more for groceries, gasoline, and daily necessities, so there’s less available to go towards your mortgage every month, making lending money riskier. As inflation heads upward, the cost of a home may increase right along with it. That’s why your debt-to-income ratio is so important. Keeping your debt low will combat inflation spikes.

The opposite is also true. A low inflation rate brings down the mortgage rate, which makes buying a home more affordable. The less expensive a home is, the less you may have to borrow, and that will indeed affect the mortgage rate you’re offered.

The Job Report

Once a month, the Bureau of Labor Statistics releases The Jobs Report, aka the Employment Situation Summary, which looks at employment trends, how many Americans are employed, what fields are hiring, average income and other details. It also includes the official unemployment rate. A strong report, showing jobs added or wages increasing, may trigger inflation which can cause mortgage rates to rise. If the report hints at a weakening economy, and there’s less demand for home loans, it’ll put pressure on lenders to make interest rates more attractive.

Remember, all mortgage rates aren’t the same 

Even if you supply different lenders with the same personal information (credit score, employment history, etc.), you’ll see a range of the mortgage rates offered. There are a number of reasons for this, besides the lender’s appetite for risk, including:

  • Overhead costs: Lenders who keep their overhead low have the flexibility to offer better rates.

  • Closing costs: Be careful — lenders offering lower rates might be hiding higher closing costs, effectively having you pay points for a lower rate.

  • Missing info: Lenders typically offer rates within a percentage point of each other. If one’s rate dramatically stands out from the rest, it may be a red flag that critical info is missing. Be sure to ask why. 

Taking the next step

The above factors all play a key role in the interest rate you’re offered. If you’re getting ready to buy or refinance a home, getting the right rate starts with the application process. We are here to answer all of your questions and help you make the right decision.

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