The Factors behind
Mortgage Rates
When you apply for a mortgage loan at a bank there are many more players involved than just your credit score and the bank. In fact, there is a long money trail and a chain of factors that contribute to the interest rate you end up paying on your mortgage loan.
The dominant factor at play in determining mortgage rates is risk. All parties involved, including you, the bank, and the others behind the scene (which we will discuss shortly) are all taking a risk. Obviously, taking out a loan – borrowing money that you hopefully will be able to pay back later – is a risk. But, the bank is also taking a risk on you! Giving you money and trusting that you will be able to repay it is a pretty big risk. If you default on your loan or end up filing bankruptcy someone along the line loses their money.
At the most basic level, interest rates – in this case your mortgage rate – serves as insurance for the bank. That’s where they make their money. The more of a risk you are, the higher your mortgage rate will be. Banks take into consideration your credit rating, made up of three different credit scores, and economic factors that affect you and your loan. For example, your job – if you work in an industry that is struggling, even though you may be incredibly responsible about paying your bills, if you might be out of work soon, you might eventually have trouble paying back your loan. So, as you can see, the
mortgage lender not only has to evaluate you and your financial situation, but the economy as well.
Your Mortgage Rate: Behind the Scenes As I said before, determining
mortgage loan interest rates are not just a two man game. This is where it gets tricky. It’s not just you and the bank; it’s not even just you, the banks, the local market and the Federal Reserve. In fact, there is a trail of interconnected institutions that end up determining your mortgage rate.
What you may not know is that the bank that issues you a loan doesn’t usually keep it. They sell it, and your loan becomes part of the secondary mortgage market.
The bank sells your mortgage to a third party investor, also known as an aggregator. The aggregator, usually a mutual fund or a larger bank, then packages many mortgages together into a
mortgage-backed security. Finally, the mortgage-backed security is split up into shares and sold to individual investors.
These investors buy the MBS shares (known as tranches) to get returns on their investment through the homebuyer’s mortgage payments. This process is in place because if the banks kept mortgages they would run out of funds and not be able to extend any more loans. The MBS system was developed to keep the housing market going.
So in reality, the bank that grants you a loan and the aggregator are just middlemen between you and the investors. Banks have to toe the line between homebuyers who want loans with low interest rates, and the investors who are more interested in MBS’s with high interest rates because they offer more in returns.
Your mortgage rate is therefore affected by how much investors are willing to pay for shares, and how much the aggregator is willing to pay for your original mortgage.
Other factors, such as inflation and the federal funds rate also affect mortgage rates. When inflation occurs it causes a problem for lenders because the money that they lend today will be worth less when it gets paid back. Therefore, during times of inflation investors insist on higher interest rates to make up for the losses.
The federal funds rate, set by the Federal Reserve, is the interest rates banks use when making loans to other banks. The Federal Reserve is the bank of the U.S. government, and it is the central bank of the United States. It is responsible for regulating financial institutions, adjusting certain interest rates, and managing the economy.
When the federal funds rate is raised, it makes borrowing money more expensive. Therefore there is less money available in the market. Obviously this will also affect lending rates.
This is only a brief overview of the factors that affect mortgage rates. As you can see, there is a lot more at play than just your credit rating and the bank that offers you a loan. Staying current with the market and following key factors that can affect your rate can make a huge difference in making an educated decision as to when it is the best time to apply for a loan.