How do mortgage rates work?

How Do Mortgage Rates Work?

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You may be wondering how mortgage rates are decided.?Obviously, you want to make sure that you get the lowest rate possible, but how are mortgage rates determined, and what can you do to make sure you have a low rate?

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There are several outside factors that affect how mortgage rates are determined today, but you can only control one aspect of your mortgage rate and that is your own personal factors. Lenders look at your qualifying factors to determine your risk level. The better your qualifying factors, the better the interest rate they’ll offer.

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Mortgage rates begin with the current market rates, so you may wonder how the market affects interest rates.

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Mortgage Rates Affected by the Economy

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Mortgage rates are affected by the overall economy. When the economic outlook is good, rates tend to increase, and rates fall when they’re not so great. Mortgage rates are determined by many elements, including the inflation rate, the pace of job creation, and whether the economy is growing or shrinking. When the economy is doing well, borrowers can afford more.

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The Federal Reserve doesn't set mortgage rates, but it does affect mortgage rates indirectly. The Fed controls short-term interest rates by increasing them or decreasing them based on the state of the economy. While mortgage rates aren’t directly tied to the Fed rates, when the Fed rate changes, the?prime rate?for mortgages usually follows suit shortly afterward.

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The Federal Reserve controls short-term interest rates to control the money supply. When the economy is struggling, as has been the case during COVID-19, the Fed lowers rates. These are not the rates given to consumers, but the rates at which banks can borrow money to lend to consumers.

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When the Fed decides they need to tighten up the money supply, they raise the Fed rate. While this doesn’t directly increase mortgage rates, eventually, banks and lenders must follow suit to keep up with their costs to borrow money from the Fed.

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Which Personal Factors Affect Your Mortgage Rate?

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You certainly cannot control the economic factors of mortgage rates, but you can most definitely control your own personal factors. Let’s dive into what you can do to get the?best mortgage rate possible, beginning with your credit score.

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Credit Score

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A high?credit score?means you’re less of a risk to lenders.?A high credit score shows that you pay your bills on time and don’t overextend your credit. When lenders pull your credit, they see you as a responsible borrower with a low risk of default.

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This leads lenders to give you a better interest rate because you are less of a risk.?

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When you have a low credit score, lenders often change the interest rate significantly because you’re at a higher risk of default for the mortgage you are getting.?A low credit score indicates that you may not pay your bills on time or that you have overextended yourself.?

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The credit score you need depends on the loan program you are using.?If you want a conventional loan, you’ll need at least a 620-credit score, but if you choose FHA financing, you’ll need a 580+ credit score for most lenders.

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Taking steps to check and?improve your credit?will put you in a better position to get a lower rate from your lender. The next factor you can control is your down payment.

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Down Payment

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Lenders want to know that you’re invested in the home through a?down payment?and that you aren’t borrowing 100% of the funds. The more money you have invested in the home, the less likely you are to default.

If you put down less than 20% on a home, your mortgage rate will increase, and you’ll need to pay?mortgage insurance. There are different types of insurance depending on your loan program; some are cancellable, and some are not.

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Besides mortgage insurance, if you put down less than 20% on a home, you’ll also pay a higher interest rate. You’re at a higher risk of default with a lower down payment, and lenders make up for the risk by charging a higher interest rate. The next thing that will affect your interest rate is your Loan-to-Value ratio.

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Loan-to-Value Ratio

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A loan-to-value (LTV) ratio compares the amount of a loan you're hoping to borrow against the appraised value of the property you want to buy. The less money you put down on the home, the higher your LTV becomes, which is a higher risk for the lender.

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When you put little money of your own into the home, you have less incentive to keep paying the mortgage when times get tough. If you have your own money invested, though, you’re more likely to do what’s necessary to make good on the debt.

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Lenders charge higher interest rates when there is a higher risk, which means if you put more money down you have more to lose.?Another factor lenders will look at when raising your risk is how you intend to occupy the house.?

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Occupancy

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Lenders care about whether your home is your?primary residence, which means that you will be living there or if the home is a second home, like a vacation property and finally if the home is an investment property that you will rent out to others. Interest rates are usually lowest on primary residences because it’s where you live. You’re more likely to make your payments on time because you don’t want to lose your home.

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If you have a second home or investment property and you have financial issues, you’re more likely to default on the mortgage, putting the lender at risk. Most lenders charge higher mortgage rates to make up for this risk.?

The Bottom Line

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The bottom line is that both market and personal factors affect your mortgage rate. While you can’t do anything about market conditions, you can control your personal factors. Improving your credit score and saving for a larger down payment are two of the best ways to improve your chances of securing the best mortgage rates.

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Be sure to take care of what you can control about mortgage rates by looking closely at your personal factors and make them as good as possible to ensure you get the best interest rates available when applying for a mortgage.?Always be sure to work with a licensed mortgage professional and get your questions answered.?