What Affects Your Mortgage Rate
Your mortgage interest rate plays a big role in how much house you can afford. What looks like a tiny change in the interest rate – for instance, from 4.2 to 4.5 percent – could add up to thousands of extra dollars over the life of your home loan, so it definitely pays to understand what impacts mortgage rates to know if you’re getting the best rate you can.
When you look at different loan offers, however, you need to compare apples to apples. There are several factors that affect mortgage interest rates, and changing just one of them can make a big difference in the rate you’re quoted.
To figure out whether a specific loan offer is reasonable, you need to know exactly what affects your rate and how. Here’s a list of some of the most important factors to keep in mind.
Federal Funds Rate
The federal funds rate is a benchmark interest rate set by the Federal Reserve. This rate, in turn, has an impact on the interest rates set by consumer lenders for their loans, including mortgage loans. Lenders tend to raise their rates as the federal funds rate goes up and drop them as it goes down, although this change doesn’t always happen right away.
Source: Board of Governors of the Federal Reserve System (US), Effective Federal Funds Rate [FEDFUNDS], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/FEDFUNDS, August 5, 2018.
The federal funds rate has varied widely over the decades. As this chart from Federal Reserve Economic Data (FRED) shows, it spiked to nearly 20 percent during the 1980s and fell to almost zero during the Great Recession of 2008.
Source: Freddie Mac, 30-Year Fixed Rate Mortgage Average in the United States [MORTGAGE30US], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/MORTGAGE30US, August 6, 2018.
The above FRED chart shows how mortgage rates changed during the same time. As you can see, mortgage rates don’t change as fast as the federal funds rate, but they tend to follow its overall ups and downs.
Although the federal funds rate is the same nationwide, actual mortgage rates can vary slightly from state to state. For instance, in July 2018, interest rates were a bit above the federal average in Alaska and a bit below average in Delaware. You can check the Explore Interest Rates tool from the Consumer Financial Protection Bureau (CFPB) to see what kind of rates are typical in your state.
Lenders generally offer their best mortgage rates to borrowers with the highest credit scores. Your credit score is a measure of how well you’ve managed debt in the past, based on factors such as how much you’ve borrowed and how promptly you’ve paid it back. Lenders desire creditworthy borrowers because they see them as less risky customers.
Size of Loan
Lenders can charge higher interest rates for both very large and very small home loans. Very large loans are risky for lenders because they stand to lose more if the borrower defaults. Very small loans, by contrast, are costly for lenders because they may have the same origination fees as larger loans, and the interest payments on such a small loan aren’t enough to make up for them.
There are two basic types of home loans: fixed-rate and adjustable-rate. With a fixed-rate loan, your interest rate will stay the same over the life of the loan. With an adjustable-rate mortgage, or ARM, the rate changes over time generally in line with changes to the federal funds rate or other interest rate index.
ARMs often have lower rates to start with than fixed-rate loans, but when the initial period ends, the monthly payment can increase, sometimes significantly. Before choosing an ARM, it’s important to review the terms carefully and find out just how fast the interest rate could rise, and whether the new payments fit into your budget if it does.
Lenders generally offer lower interest rates for shorter-term loans than longer-term ones. For instance, as of July 2018, rates for 15-year fixed mortgages were about 0.6 percentage points lower than for 30-year mortgages, according to the Explore Interest Rates calculator.
However, the monthly payment is higher for a shorter-term loan because you’re paying back a bigger chunk of the principal each time.
Lenders are often willing to offer you a better interest rate if you make a large down payment – at least 20 percent of the purchase price. Putting down this much money shows that you’re committed to this home, so lenders see you as a lower-risk borrower. If you can’t manage a down payment of at least 20 percent, most lenders will require you to purchase private mortgage insurance (PMI), which protects them in case you default on your loan.
Discount points, or “points” for short, are up-front fees you can pay to lower the interest rate on your mortgage loan. One point is equal to 1 percent of the total loan cost. For example, if you take out a $200,000, one point would cost you $2,000 at closing. Adding one point will typically lower your interest rate by approximately 0.25 percentage points. Additional points lower the interest rate further, though not always by quite as much.
Ethos Lending is a new type of mortgage lender. We use technology to keep our operational costs as low as possible. From closing costs to interest rates, we have made it our mission to make the process of buying a home more affordable. Get in touch with one of our mortgage specialists to learn more.