At Local Mortgage, our team is passionate about helping people get into the home of their dreams while saving money in the process. In today’s article, we will discuss the basics of interest rates, how they are determined, and give you an idea of how to compare and find the best interest rates. If you are a first time homebuyer or looking to refinance, and you feel unclear about interest rates, then this is the article for you
Many people have a basic understanding that interest rates are crucial to mortgages and that they affect the monthly payment you end up making. The lower the rate, the lower the interest you pay on your loan and the lower your overall payment. That part is pretty easy.
That said, interest rates are often discussed without an explanation of what they are. Since many lenders work with interest rates every day, they may not take the time to help their clients gain a solid understanding of how rates work.
The Basics of Interest Rates
You can think of interest rates as the cost of borrowing money. In the case of loans specifically, interest rates are the price you pay the lender for taking on the risk of letting you borrow their money. The riskier the loan, the higher the interest rate the lender needs as payment for them providing the loan. If the loan is deemed to be less risky, lenders will typically offer a lower rate. Factors that will determine the rate you are offered are your credit score, loan to value ratio, loan purpose (purchase, rate term refinance or cash out refinance), property type and occupancy.
In the case of mortgages, interest rates are typically lower than the other loan types, primarily because mortgages are loans are collateralized by the home you are purchasing. In addition, if you are getting a traditional secondary market loan such as a Conforming loan or Government insured loan such as FHA, VA or USDA, those loan types are securitized by agencies, creating large pools of loans where risk can be spread over hundreds or thousands of loans. Investors purchasing these securities spread their risk over an entire pool of loans which helps lower the overall rates for secondary market mortgage loans.
Secondary Market
The secondary market for mortgage loans is made up of investors, lenders and agencies. Investors are individuals, banks, insurance companies, brokerages, or hedge funds that are looking to invest in relatively safe assets. They buy mortgage backed securities from lenders or agencies that create securities for sale on the secondary market. These securities are made up of hundreds or thousands of loans that generally have similar characteristics. The interest that we pay on our mortgages flow through our servicing lenders and to the investors that own the securities to which our loans belong.
Since all secondary market loans are made with the intent to sell to the secondary market, the investors in the secondary market ultimately determine and influence the movement of interest rates. As the appetite for safer assets increase in the market, rates will typically fall as investors buy more mortgage backed securities. Inversely, if there is less appetite in the market for safer assets, rates will typically increase since there are less buyers and higher rates are needed to attract investors back to mortgage back securities.
Discount Points vs. Lender Credit
Now that you understand that rates are determined by investors in the secondary market, let’s discuss how your particular lender determines your actual rate. Lenders have a range of rates that are being sold in the market at any given time.
For example, at the time this article is being written, investors are buying 30 year securities with interest rates from 2.25% to 4.25%. Secondary market investors will obviously pay your lender more for a loan with a higher rate than one with a lower rate. Lenders will determine their own margin which will ultimately determine how competitive their rates are.
After applying their margin, the “par rate” is the rate at which the lender is making their margin through the sale of your loan, therefore, they would not need to charge you any additional “points” to make their intended margin on the loan. This is sometimes referred to as a “no points” transaction.
For a loan with a lower rate than the par rate, the lender is making less than their intended margin, so you would have to pay the difference. This difference you pay is typically called a discount point. You would be paying more in closing costs in exchange for the higher interest rate.
Inversely, you could choose a higher rate than the lenders “par rate”, which would result in the lender making excess revenue on your loan. Under this scenario, you should receive “lender credit” towards your closing costs. So instead of paying extra cost to get a lower rate, you are accepting a higher rate for lower closing costs. This is a very useful strategy, especially for refinances. If you are interested in this, be sure to read about our no closing cost loan options.
Start Your Mortgage Calculations with Local Mortgage
If you are looking to buy a house for the first time or you need to refinance, then contact Local Mortgage. Our team of experts is here to help you through the process and find the right mortgage rate for your needs.