Factors in Mortgage Interest Rates

TAGS: Interest RatesFAQsHomebuying
Factors in Mortgage Interest Rates
Article Excerpt

Your mortgage’s interest rate will affect how much you pay each month. Learn more about the factors that may affect your interest rate.

Mortgages have enabled countless people to buy their own homes. A mortgage is a type of loan specifically designed for the purchase of a home. The lender provides most of the money, typically minus the borrower’s down payment. The borrower signs a promissory note. This document obligates the borrower to repay the loan according to certain terms, including the amount of time they have to pay the loan and the interest rate.

A mortgage’s interest rate significantly affects the amount that the borrower must pay each month, as well as the total cost of the mortgage over its lifetime. Homebuyers should choose carefully when seeking a mortgage loan. A mortgage’s interest rate is the result of many factors, only some of which might be within a borrower’s control. Some of the factors involve large transactions between financial institutions that occur far away from the mortgage lending process.

What is interest?

Interest is the fee that you pay to a lender for loaning you money. The lender is letting you use their money with the understanding that you will pay it back. Interest is how they make money on the deal.

When you rent a car, you pay a daily rental fee to the rental company in exchange for the use of the car. You have to sign a contract that specifies when and where you must return the car, and what may happen if you don’t do so. The longer you have the car, the more you must pay.

cars in a parking lot

Interest is similar to the rental fee. The loan agreement is similar to the rental agreement you sign before you get the car. You must make payments on the loan, plus interest, at specified times, and you must pay off the entire principal of the loan by a certain date. The longer the loan remains outstanding, the more interest you will pay.

Borrower-Controllable Factors

Mortgage lenders consider many factors when determining how much interest to charge a borrower. Some of these factors, such as credit score, income, and debt-to-income ratio (DTI), are unique to each specific borrower. These factors might be within the borrower’s control, at least to some extent.

Choosing a fixed-rate mortgage

With a fixed-rate mortgage, the borrower agrees to repay the loan at a specific rate of interest that will not change over the life of the loan. This offers stability to the borrower in terms of budgeting their monthly mortgage payment. It also shields them from abrupt changes in interest rates.

Choosing an adjustable-rate mortgage

An adjustable-rate mortgage, or “ARM,” might start with lower interest than a fixed-rate mortgage. As the name indicates, the lender can change the interest rate on the loan according to the terms of the loan contract. The lender is not locked into an interest rate and can make adjustments based on market forces. The rate can go up, and then back down.

A borrower with an ARM might have to change the amount of their monthly payment each time the interest rate changes. This can make budgeting more difficult.

graph showing adjustable rate

Photo by Tech Daily on Unsplash

Choosing loan terms

The term of a mortgage loan also affects the interest rate. The mortgage loan industry needs to keep money flowing so that lenders can keep making new loans. A 15-year mortgage will typically have a lower interest rate than a 30-year loan as a way to encourage borrowers to pay off their loans more quickly.

Typically Unseen Factors Influencing Mortgage Interest Rates

Other factors, like general market conditions and financial policy, are beyond both borrowers’ and lenders’ control. A mortgage lender might be able to offer a lower interest rate to a borrower with good credit, but there’s only so much they can do, depending on other factors happening at a national level.

Mortgage lenders must get the money to make loans from somewhere. Lenders may borrow money from banks, which may borrow money from the Federal Reserve (“The Fed”). Entities like Fannie Mae and Freddie Mac buy mortgages from lenders in order to provide them with liquidity to issue more loans.

» READ MORE: Where Do Mortgage Lenders Get the Money to Fund Loans?

Many of these transactions use distinct interest rates. While borrowers might never directly encounter these types of interest, they are important factors in mortgage interest rates.

Federal Funds Rate

The Fed, in the popular imagination, has the authority to “raise interest rates.” In reality, a Fed committee has the power to set a specific interest rate, known as the federal funds rate, for loans between large commercial banks.

This rate acts as a sort of minimum rate for the entire economy. As goods move from a manufacturer to a distributor, and then to a retailer, the price increases with each step. The federal funds rate has a somewhat similar effect on interest rates for loans made by large commercial banks to smaller banks and other lenders, loans from smaller banks to businesses or individuals, and so on. In this sense, the Fed actually does have the power to influence interest rates.

Commitment rate

When Fannie Mae and Freddie Mac buy mortgages from lenders, they must make it worth lenders’ while. They pay an extra amount, based on a percentage of the outstanding loan amount, known as a commitment fee. The purpose of the fee is to compensate the lender for committing to continuing to lend the money.

Prime rate

Large commercial banks might give a favorable interest rate to certain corporate customers considered to be creditworthy. This “prime rate” is based directly on the federal funds rate.

Get a grip on the mortgage process!

Finding the right mortgage can seem like a stressful process. You have to look at interest rates, loan terms, and other features to find a solution that works best for you. The home mortgage professionals at The Wood Group of Fairway are here to help. Get started with the lender Texans trust right now!