How Are Mortgage Rates Determined?

How mortgage loan rates are determined and what causes them to move is an absolute mystery to most folks – and those who think they know are usually wrong. As a former mortgage banker I can tell you that a lot of people in the mortgage industry can’t even give you an accurate answer to that question. So what’s the mystery and misinformation all about? Let’s take a simple look, in plain English, at what moves mortgage rates and (just as importantly) what does not.

Ask a bunch of your friends what mortgage rates are based on and they will tell you they are not sure but it has something to do with Ben Bernanke and the Federal Reserve. Some of your more financially savvy friends may tell you that rates are based on the 10 year treasury yield. Both answers are incorrect. The simple truth is that mortgage rates are based on the mortgage backed securities (MBS) market. I know – this is starting to sound scary. I promise to keep it simple – here’s a quick explanation of what a mortgage backed security is. Banks and mortgage lenders take large bundles of their mortgage loans and pool them together to be sold as investments. These debt obligations trade as bonds (mortgage backed securities). An investor can invest in a pool of mortgage loans and receive income based on how those loans perform (do they pay on time etc…). The mortgage backed securities market is a segment of the overall bond market. The MBS market reacts and moves based on economic news and indicators similar to how the overall bond market works.

To take this one step further, here’s the technical explanation for those of you who are knowledgeable in matters of finance. MBS rates, and consequently mortgage rates, are directly determined by variances (or spreads) between it (MBS Rates) and a financial derivative instrument called interest rate swaps. These swaps are used by investors to manage, hedge, or speculate on risk. The rate on a swap rate is a fixed interest rate that one would receive in exchange for the uncertainty of having to pay the short-term LIBOR (London Interbank Offered Rate) rate over time. Additionally, mortgage rates are influenced by relative spreads between interest rate swaps and treasury notes.

So why does everyone think that the Federal Reserve controls mortgage rates? Your guess is as good as mine. The most likely cause is that misinformed people in the media just keep talking about the fact that the fed lowered interest rates and mortgage rates will follow suit – and we keep listening. The fact of the matter is that the actions of the Federal Reserve do have an impact on mortgage rates but it is indirect and often extremely delayed. When the fed announces that they are lowering short term interest rates, this has an immediate impact on some types of consumer loans such as home equity loans and credit cards. It also has a negative affect on the interest rates on saving vehicles like money market accounts and certificates of deposit (because those rates go down as well). It does not however, have an immediate or direct impact on mortgage rates. The indirect impact on mortgage rates of the fed easing (lowering) short term rates is that it causes investors to flee investments like money markets and CDs and put more money into the stock and bond markets. When people buy more bonds (including mortgage backed securities) this causes bond prices to rise. When bond prices rise, the yields of those bonds go down. Lower yields on mortgage backed securities equal lower rates. This chain of events that started with the fed lowering rates and ended with mortgage rates going down could take months to unfold and dozens of other economic events could intervene and keep that chain of events from happening as predicted.

The other common misconception is that mortgage rates are tied to the long term Treasury notes. Not true. If you look at long term charts for mortgage rates and long term treasuries side by side you will see that they trend together over a long period of time. As mentioned above, the spread between interest rate swaps and treasury notes do influence mortgage rates – but it is inaccurate to say that there is a direct link between the two.

We’ve just covered the basics on how long term mortgage loan rates such as the 30 year fixed rate are determined. Short term mortgages like 5 year ARMs and 7 year ARMs can be based on a number of different indices.

Mortgage Rates Comparison Sites – Do They Give You the Whole Story?

If you are contemplating your first mortgage as a first time buyer, or a remortgage of your existing loan, you would probably think that researching the best mortgage rates would be as simple as going to the nearest price comparison site, answering a few straightforward questions and applying a few filters to suit your mortgage rate requirements.

Now for price comparison sites that make millions from online financial arrangements, that view is one that they try to foster, indeed actively promote. Why wouldn’t they? It makes them millions. Giving advice requires expertise, time effort, adherence to strict Financial Services Association rules, and above all a desire to really make sure the most appropriate advice is provided, even if the advice means no income is generated for the adviser.

Oh, but that doesn’t make money. Far easier to place the decision with the client, and allow them to make the decision. Now I’m all for people power, and people taking responsibility for their own actions, but does it make sense for the largest financial commitment most of us ever consider to come without even the smallest amount of mortgage advice.

Having spent more than ten years providing mortgage advice online talking to people from all walks of life, I am of the firm believe that advice should be made compulsory. All too often I have seen the consequences of an ill considered decision causing problems later on. Mortgage rates believed to be fixed only to turn out to be a discounted rate, where the mortgagee misunderstood that the discount rate was fixed, not the actual pay rate. Those with extended redemption penalties that they had just not realized were present because they hadn’t read the documentation correctly. They were only really concerned about the monthly payment.

Well if you are considering a mortgage, and what mortgage rates will be suitable, my advice would be that you talk to an Independent Financial Adviser. Fee or no fee, seeking advice will always save you money in the long run.

For those that don’t feel professional advice is for them, perhaps just consider the following points when mulling over which mortgage rates are best for you.

Attitude

Do you have a real understanding of the differences between the different types of mortgage rates? Has media hype, adverse publicity or the advice of friends lead you to discount a particular type of mortgage that may be suitable for your needs.

Changes in Circumstances

Do you know what you will be doing in two, three, five or more year’s time? Do you plan to start a family? Is there any expectation that your income may go down? Do you expect a promotion, relocation, and if you did, would you retain the property and let it out lender permitting, or sell it? Might you move abroad, and would that impact on the mortgage repayment type considered?

Early Repayment Charges

Does the mortgage have one, and if so is it just during any product period such a three year fixed rate, or does the penalty extend beyond the benefit period leaving you with the prospect of paying the generally higher lender standard variable rate, or the payment of a penalty which is often equivalent to six months interest?

Can the mortgage be transferred to a new property without incurring the redemption penalty?

Portability

Whilst most mortgage rates are portable to a new property some are not. For those that are you should be aware that portability is not a ‘Right’, but rather just a feature of the mortgage product. To transfer a mortgage to a new property you will still need to meet the lenders underwriting criteria again, and the property will still have to be a suitable security. Also consider the repayment method you select. If you expect to move frequently, is a repayment mortgage advisable? Or would you be better of with an interest only loan and a savings plan that is independent of the mortgage?

Overall APR / Cost for Comparison

Which mortgage is the cheapest, and how do you assess it? Is the cheapest mortgage the best mortgage, after you take all the other factors into consideration? Total cost comparison is a good place to start however. Beware though, as this is the one calculation that many online mortgage sourcing systems do not provide. Comparing the total cost over a given period which includes all the relevant fees and charges will provide a list of products in total cost order. Whether the one at the top is the most appropriate mortgage is a different question.

Affordability

The monthly payment is always a major consideration. Typically a two year discount or tracker mortgage rate will provide the lowest overall cost over that period. Fixed rate security often comes at a premium. Would it be cheaper if interest rates were to rise? How much could they rise before the fixed rate mortgage becomes a better option? And more importantly if they were to rise at what point would the loan become unaffordable?

Flexibility

Does the mortgage allow for overpayments or underpayments where an overpayment has been made? Will it allow for the offset of mortgage interest against a linked savings account? Can you switch from repayment to interest only in the event of financial difficulty? Can you select if overpayments will reduce the term or the monthly payment?

The above are just a few considerations, and can often leave you more confused than before you started, and this is often when the lowest monthly payment becomes the main factor for mortgage rates selection.

The reality is that most mortgage rates are unable to satisfy all your needs, and seeking advice ensures you know which mortgage rate is the most appropriate for your needs having considered all the important factors.

The Shopping for a Mortgage Rate Game

I have been advising borrowers who need residential mortgage financing for over seventeen years. My experience shows that no matter how sharp, intelligent, smart, educated, or ignorant a borrower is — the mortgage rate trap that they all fall into is the same. Unfortunately, by the time a borrower realizes that they have been misinformed, mislead, or just been given only part of the mortgage rate story; their inept, inexperienced, unknowledgeable, and eventually disinterested loan officer/customer service rep has earned an undeserved commission.

How many times do I sit and answer my phone only to hear “Hi, I was referred to you by so and so, and uh, I’d just like to know, uh, what is your rate is today?” My mind races with “Are you in contract? How much are you looking to borrow? What is the size of your current mortgage? What is the purchase price? How is your credit? Can you verify income? Are you locking the rate? How long are you looking to lock the rate for? When are you looking to close? Do you own any other properties? Are you buying the property to live in or for an investment? What type of property are you buying?” You see, the answer to all theses pertinent questions (and more) EFFECTS THE RATE! This warrants repeating one more time — the answer to all theses pertinent questions (and more) EFFECTS THE RATE! So, I say to the respective caller while qualifying my answer, “If you have good credit, can verify your income, intend to live in the property, and can show enough liquid assets to buy the property than the prevailing mortgage rate is X.”

Please understand, I do not blame borrowers for asking the question, BUT, I, as a mortgage professional, get frustrated seeing consumers, make the biggest financial decision of their life based on misleading advertisements and other information or lack thereof. The kicker is, that many mortgage companies’ advertisements and customer representatives confuse and/or mislead the consumer into applying for a mortgage with their company while legally and ironically complying with the federal laws set up by our government to protect the consumer. When do you or the borrower find out that the rate and closing costs are not what they appeared to be — AT THE CLOSING! The old bait and switch is still around, but even more costly is the withholding of relative information. Many mortgage officers feel they have a greater chance of closing your mortgage when they give you a direct answer to your direct question without volunteering the other pertinent information you would want to know, if you knew enough about mortgages to ask. This other information used in conjunction with the “what is your rate?” question can save you big bucks at the closing table and over the life of your loan.

There are many variables that go into each and every mortgage deal, and every deal is unique unto the borrower. I will try to provide you with some a general guideline of the “other information” you need to be aware of, so that you will be able to shop for mortgage rates intelligently, and, if you so desire, select a mortgage professional who knows what they are doing which may, consequently save you thousands of dollars.

1.Rates fluctuate daily. Some lenders lag behind the market, and some lenders adjust immediately to the market.

2. A conforming mortgage conforms to Fannie Mae and Freddie Macs; (the biggest purchasers of mortgages) underwriting guidelines. Their 2007 loan ceilings are: 1 family homes $417,000 2 family homes $533,850 3 family homes $645,300 and 4 family homes $801,950. The rates are generally competitive among lenders give or take an eighth to a quarter of a rate. “Jumbo” mortgages exceed the conforming ceilings. Jumbo rates are usually higher than conforming rates.

3. Occupancy affects rates. A primary residence is occupied by the borrower. A rate may have an add- on (increase), if the property is a second home, vacation home, or if the property is used for investment (you rent it out).

4. Loan to value (LTV) is the mortgage amount divided by the value of the property. The higher the LTV, the greater the risk to the lender, and the possibility of a higher rate.

5. A cash out refinance (cash over and above your existing mortgage) may incur an increase in rate depending on the lender.

6. Generally, the shorter the loan term (30 year vs. 15 year), the lower the rate.

7. The better the credit the better the rate. Today lenders are really focused on a credit score. A number determined by comparing your credit pattern and history to the credit bureaus database of proprietary mathematical formulas and models of historical consumer credit patterns. If your score is low, you might be a candidate for re-scoring your credit (legally) to bring up your score and consequently give you an opportunity for a better rate. Make sure that your time frame for getting the money you need coincides with the time it takes to correct or repair your credit. Otherwise, the time it takes to correct or repair your report may prevent you from taking advantage of current low rates or special deals which defeats the whole purpose (“A bird in the hand…”.)

8. Compensating factors affect the rate. The lender may offer you a lower rate because of a low LTV. A great credit score with borderline income may allow you to squeeze into a better mortgage rate.

9. Mortgage Brokers and Lenders have different programs for different types of borrowers. Generally, the more financial information you supply the better the rate. The programs are: Full income Full asset verification, No income with asset verification, No income No asset verification, and Stated income with asset verification. The key is to make sure that you match yourself to the right program so you not only get the appropriate rate, but to also make sure you don’t get turned down. For example, you apply for a full income full asset loan program, but you do not show the income needed to qualify on your tax return, but you may have qualified on a No income verification type of program.

10.There is, or supposed to be, a correlation between rates and points. A point is an up front fee of 1% of the loan amount you are borrowing. “Buying down the rate” means paying points to lower your rate. “Buying up the rate” means, paying fewer points to increase the rate. You would most likely want to pay points if: (a) you need to lower the rate to qualify (b) you will own the property long enough to amortize (recapture) the point money you paid up front (c) You have the extra cash. You will most likely not want to pay points if: (a) You don’t have the extra money (b) You will own the property for a very short time (c) You think rates are going to decline shortly. There are other reasons for paying and not paying points, which should be discussed on a case-by-case basis.

I have saved the best for last!

11. LOCKING THE RATE. When you call and ask “what is your rate?” you will generally get quoted the prevailing rate, a/k/a as the floating rate, which means, if you are ready and able to close within 15-21 days (which means you have applied for a mortgage, supplied your financial information, have a commitment from the lender, an appraisal, a title report, etc.), and you locked in the rate right now, this is the rate you would get. Now, how many first time homebuyers do you think fit that situation, Hmmm? Most residential purchase real estate transactions do not realistically fit a prevailing rate time frame. Most borrowers are not informed, at the time they are quoted the rate, about the if you are ready to close in 15-21 days closing time frame. Therefore, if rates are dropping, fine. BUT, if rates are increasing — Surprise!

Prevailing rate quotes will always be lower than locked in rate quotes. So, if you are rate shopping and want to compare apples to apples, when you are quoted a rate, the key thing is to make sure you ask: “How long the rate is locked in (protected) for? Are there any points, origination fees, broker fees? What lock-in time frames are available?” More importantly, make sure you can close within that time frame otherwise you may be subject to extension fees. Generally, the longer the lock the more it costs. Lock in periods are usually 15 days, 30 days, 45 days, 90 days, 120 days, 180 days. Paying points, increasing the rate, or both, incorporates the cost of the lock. You may want to ask if a float down option is available (if the rate drops after you lock can you get the lower rate.) More importantly than getting a rate lock agreement in writing, make sure the person you’re dealing with is honest, reputable, and whose word means something.

12. The APR (Annual percentage rate). I call it Another Proven Rip-off. A borrower is supposed to be given the APR along with the closing costs and rate information. If you look in the newspaper adds you will often see a rate advertised about one half to one percent lower than the real market rate. If you look on the side of that rate you will see what is known as the APR. This advertisement is perfectly legal, as long as the rate stated is accompanied by the APR rate, but in reality this is very tricky. According to the federal regulation Z, the APR is supposed to be the measure of the true cost of credit, expressed as a yearly rate. The government is trying to assist you, the consumer, in your loan decisions by making loan providers give you the APR “true cost of credit.” They mean well, but, unfortunately, most people do not have the sophistication, knowledge, time or financial calculator needed to figure out the APR. Long story short, by taking the loan amount, the rate you are quoted, and factoring closing costs into the calculation you arrive at the APR. So the rate you see in the newspaper that appears to be lower than everyone else means nothing unless you know exactly what the closing costs are. In these cases, the APR conceals the closing costs. You will find out that most of these advertised below market rates have several points built in to the closing costs. When mortgage shopping, instead of comparing APR’s, for your sake keeps it simple. Find out the rate, how long it’s locked in for, and all closing costs included and then compare. I hope this article helps you save thousands of dollars and good luck to all mortgage shoppers.