Mortgage rate is the rate of interest charged to a borrower on a mortgage. A mortgage loan is a secured loan that enables borrowers to raise funds by pledging their property. It is a major financial commitment with severe consequences locking borrowers into a spiral of payments.
Thus, mortgage rates are one of the primary factors considered by homebuyers looking to finance a new home purchase via mortgage loans. Other factors taken into account are collateral, principal, taxes, insurance, etc.
The rate of interest charged to a borrower on a mortgage is called the mortgage rate, which can be either fixed or variable.
Several economic and personal factors determine mortgage rates, including inflation, credit score, level of economic growth, loan-to-value ratio, etc.
Economic uncertainty amid a spike in the cases of coronavirus has kept mortgage rates to record lows in the United States.
Fixed-Rate Mortgages vs. Adjustable-Rate Mortgages
Fixed-rate mortgages (FRMs) are home loans, which charge borrowers a fixed interest rate that does not change throughout the loan term. One of the biggest advantages of a fixed-rate mortgage is that it is not influenced by the prevailing market rates, making it easier for borrowers to set household budgets and account for any unexpected changes.
However, in the case of FRMs, there’s interest-rate risk involved for both borrowers and lenders. A fixed-rate mortgage will come with a higher risk for a lender and a lower risk for a borrower when interest rates are rising and vice-versa.
Adjustable-rate mortgages (ARMs), on the other hand, are mortgage loans whose interest rates change periodically due to changes in market conditions. Thus, the primary risk associated with ARMs is that due to a change in interest rates, mortgage payments over time may become so high that they are difficult for the borrowers to meet. However, they typically come with lower starting rates than fixed-rate mortgages.
Inflation – a gradual upward movement in the price level – is a critical factor for mortgage lenders as it tends to erode the purchasing power of a currency over time. Inflation can help lenders in several ways – when inflation causes higher prices, the demand for credit increases. Hence, mortgage lenders generally try to adjust interest rates at a level that is sufficient to avoid distortion of purchasing power.
For example, if mortgage rates are at 7%, but the annual inflation level is at 2%, the real return on a loan is only 5%. Therefore, mortgage lenders carefully monitor the rate of inflation and adjust rates accordingly to ensure that their interest returns represent a real net profit.
Mortgage rates are also influenced by several growth indicators, such as Gross Domestic Product (GDP) and employment rate. Higher levels of economic growth generally produce higher incomes and encourage consumer spending, which in turn leads to more consumers seeking mortgage loans for home purchases. Thus, the upswing in overall demand for mortgages leads to higher mortgage rates.
Rising unemployment and falling wages, on the other hand, lead to decreased demand for home loans and, consequently, lower mortgage rates.
Monetary Policy is the action that a Central Bank takes to influence the amount of money in the economy and how much it costs to borrow said money. This supply of money and the cost of borrowing is almost always administered by the country or region’s central bank and can either spur or check an economy’s growth.
One of the key ways that Central Banks execute their Monetary Policy is by setting policy or lending rates. This may take the form of overnight borrowing rates for financial institutions in that country or jurisdiction most commonly.
These actual changes (or even rumored changes) in official rates will flow into market rates that mortgage investors demand for their capital, as well as the lending rates of the banks, thus impacting the mortgage rates being offered at your retail bank or mortgage lender.
4. Housing Market
Mortgage rates are also affected by conditions and trends in the housing market. When a greater number of consumers opt for rental homes or fewer homes are being built or offered for resale, the decline in home purchasing leads to a fall in demand for mortgages, which then results in lower mortgage rates.
1. Credit Score
Mortgage rates are determined partly based on the creditworthiness of the borrower. The higher the credit score, the lower will be the risk of default, and the lower will be the interest rate.
Fannie Mae and Freddie Mac require older versions of FICO credit scores – from Experian, TransUnion and Equifax – to determine whether an individual qualifies for the mortgage and to determine risk and the likelihood of default.
However, in the case of credit card companies, it is most likely that they’ll use a newer version of FICO. VantageScore credit scores, an alternative to the FICO scores, are also used across industry platforms and credit rating agencies like S&P Global, Fitch Ratings, etc.
2. Loan-to-Value Ratio
The loan-to-value ratio compares the mortgage amount with the value of an asset.
LTV = Mortgage Amount / Purchase Price or Appraised Value of Property, whichever is lower
The higher the LTV ratio, the greater the perceived risk of default, and the higher the mortgage rate. For example, if a house is purchased for $200,000, and the down payment is $40,000, then the loan-to-value ratio would be 80%. If the loan-to-value ratio is more than 80%, the lender is at greater risk, resulting in a higher mortgage rate.
Mortgage Rates Today
Economic uncertainty amid a spike in the cases of coronavirus is keeping mortgage rates to record lows in the United States. The benchmark 30-year loan rate in June 2020 is at its lowest over the past 50 years, with Freddie Mac reporting the average rate at 3.13% compared to 3.73% a year ago.
The Federal Reserve’s stance to buy up mortgage-backed securities and keep interest rates low are significantly contributing to low mortgage rates in the U.S. market, thereby, increasing affordability for buyers and refinancing homeowners.
For example, on a $300,000 loan, the overall monthly payment would be $1,298 in June 2020 compared to $1,448 in 2019. The monthly payment is inclusive of principal, interest, estimated taxes, and insurance.
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