Mortgage Rate Basics: What They Are and How They Work
By Mike Genna
If you’re like us, you occasionally hear chatter at your family barbeque about how interest rates are low and “now is the time to buy!” We all nod and pretend we understand what they’re talking about before losing ourselves in the food and conversations.
Here we are going to answer the questions of what mortgage rates look like, how they are determined, and why you should pay attention to them.
What are Mortgage Rates?
First, it’s important to understand that mortgage payments can be divided into subsections: principal, interest, taxes, homeowners insurance and private mortgage insurance. When people talk about ‘rates’ they’re referring to the interest rate that the mortgage lender charges you.
By law, mortgage rates, along with any other form of interest payment in the United States, must be expressed in an annual percentage rate format (APR). APR tells you the expense, expressed as a percentage of the principal, in borrowing that amount of capital for one year. What APR does not tell you is the added effect of the time value of money, otherwise known as compound interest.
Compounding interest is the effect of earning or owing interest on interest. This does not change your APR since interest on home loans are compounded on a yearly basis; however, in the long run, you will end up paying a slightly higher amount in interest than what seems to be advertised. That slightly higher percentage you end up paying is known as the Effective Annual Rate (EAR).
As for mortgage security, there are two parts that can be bought and sold: the Mortgage Servicing Rights (MSR) and the note. This can be a little confusing. Most people who own a home assume that the institution to which they issue their payments is also the holder of the note. This is often not the case. Purchasing homes can give an investor stable income for the duration of their mortgage; however, they would need hundreds of thousands of dollars to purchase notes. Aside from the actual note, investors and companies can purchase the mortgage servicing rights to the loan; meaning they collect payments and rightfully distribute them for a fee.
How Are Mortgage Rates Calculated?
Believe it or not, mortgage rates are beyond the control of your lender. Without a secondary market, lending to homeowners would be a rough business. Institutions could not stomach having capital tied up for 15 or 30 years as the homeowner gradually pays it back. Institutions, namely banks, sell the note to other investors at an interest rate they are willing to pay. So essentially, the bargaining on the secondary market is what determines your interest rate.
Moreover, there are several internal factors that can affect your interest rate such as your credit score, the location of your home, the price of your home, how much you’re putting down, the duration of your loan and your loan type.
Why Do Mortgage Rates Fluctuate?
Interest rate fluctuations in mortgages could be based on a multitude of factors. A good rule of thumb is that rates move up and down with the overall market. More specifically, the performance in stock and bond markets will have a direct effect on yields that investors will demand on mortgages and mortgage-backed securities (MBS). If U.S. stocks are in a bull market, investors will respond by demanding higher yields on their investments; thus, increasing the interest rate banks must charge on homes to stay competitive. Vice versa, if U.S stocks dive, investors will settle for lower yields and mortgage rates will fall lower. Since the secondary market is open to international investors, the same rule applies to foreign markets.
Another big factor in the swing of mortgage rates is inflation. Inflation can be explained as the increase or decrease (deflation) in the purchasing value of money. If inflation is consistently steady or declining, interest rates will decrease because the purchasing power of money is weak; generating lower investor yields. On the flip side, rising inflation can create unnecessarily high valuations, pushing investor yields higher; thus, raising interest rates.
Why, And, How Should You Keep Track of Fluctuations?
All in all, unless the stock market loses 20% in one day, mortgage rates will not typically fluctuate by more than 0.1% on a weekly basis. Keeping track of mortgage rates over a period of months will give you a better idea of when to sign that promissory note, which, in simpler terms, is your promise to pay the loan back.
Online tools that allow you to compare loan offers in the region are found all over the web. Many sites even allow you to track average mortgage rates on a weekly basis. These resources can help you determine the right time to lock in, so you get the best mortgage rate!