How Do Mortgage Rates Work?

Most people don’t pay a whole lot of attention to the mortgage industry unless they have plans to purchase or refinance a home. Once you are in the market, though, you’ll quickly notice that mortgage rates and how they work can have a major impact on what you’ll pay over the lifetime of the loan.

While 1 percentage point may not seem like much, it will actually significantly increase your interest payments over a 30-year term. For example, if you purchased a $200,000 condominium with a $160,000 mortgage after the down payment, you’d pay $30,000 more in interest at a 4% mortgage rate vs. 3%. That’s a lot of money!

How do you ensure you get the best possible interest rate? Well,  it all depends on several factors, starting with understanding how mortgage rates actually work . Let’s review how.

What Is a Mortgage Interest Rate?

A mortgage interest rate is essentially the amount you’re paying on top of your mortgage over time in order to take out the loan.  

It’s important to understand that there are two types of mortgage interest rates: fixed rates and adjustable rates. These two types of rates act exactly as they sound. A fixed-rate mortgage has the same interest rate through the entirety of the loan, while an adjustable-rate mortgage (ARM) has an interest rate that could fluctuate.

To understand how your adjustable-rate mortgage might change, you should ask your lender these questions:

  • How frequently could my rate adjust?
  • How soon could I see an increase in my payment amount?
  • Is there a cap or limit on how high or low my interest rate can go?

Asking these questions will help you understand how your adjustable-rate mortgage can fluctuate over time. The last thing you want with your mortgage is an unexpected increase in the rate or payment amount.  

What’s the Difference Between Mortgage Rate and APR?

You may see your mortgage rate shown alongside an additional percentage called an APR. This number is often higher than your mortgage rate and can be confusing to understand. APR stands for “Annual Percentage Rate” and is a combination of your mortgage rate along with the fees, points and other associated costs.

So, the reason your APR is generally higher is that it takes into account all of the other costs and fees associated with your mortgage.

What Determines Mortgage Rates?

While the Federal Reserve does not set mortgage rates, it can indirectly affect them through the “money supply” or the existing amount of dollars currently in circulation.  Mortgage rates are also affected by Fannie Mae and Freddie Mac and the packaging of mortgage-backed securities which then trade on a secondary market.

In general, mortgage-backed securities are a safer security than alternative investments like stocks or corporate bonds. Therefore, when investors are seeking safety during uncertain times, demand for mortgage bonds typically increases. An increase in the price of mortgage bonds will push mortgage rates downward.

Each lender has the freedom to set their rates at whatever they want them to be, and are typically based on several economic factors:

Strength of the Economy

Mortgage rates have historically fluctuated along with the economy. When the outlook is slow economic growth, mortgage rates tend to fall. This is typically a time when inflation is also falling and unemployment rates are higher.

On the contrary, mortgage rates rise when the economic outlook is forecasting fast growth. When this happens we also see unemployment rates fall and inflation rise.

Inflation Rates

Because inflation rates are affected by the strength of the economy, there is a direct correlation between inflation rates and mortgage rates. When inflation rates rise, mortgage rates generally rise as well. How does this happen? As inflation goes up, the dollar loses buying power. To compensate for this, lenders need to increase mortgage rates. Additionally, the Federal Reserve might reduce the money supply which means less money to go around for lending and investment. Interest rates are really the cost of borrowing money. Less money to go around means higher rates to obtain that money. These are indicative of a strong economy. And when the economy enters a slower growth period, inflation and mortgage rates can plunge.

Employment Rates

High unemployment rates can affect mortgage rates. We have seen this recently as a result of the COVID-19 pandemic. Shortly after the pandemic hit the U.S., unemployment rates skyrocketed and subsequently caused mortgage rates to fall even lower than they already were.

This has been the typical pattern during every recession throughout history. Unemployment rates can affect inflation and the strength of the economy. With an increase in the number of people out of work, consumer spending tends to decrease and that includes mortgages.

Consumer Spending

Consumer spending can have a drastic effect on the economy and on mortgage rates. Consumers tend to spend more when they have excess disposable income, a positive result of low unemployment rates.

When consumers start spending more, we typically see an increase in mortgage rates. This is indicative of a surge in inflation and a fast-growing economy.

It’s easy to see that all of these factors have an effect on each other. It really all comes down to how the economy is performing as a whole.

How Do I Know What My Mortgage Interest Rate Will Be?

As previously mentioned, there are a few factors that go into determining your mortgage interest rate. The factors listed above are outside of your control because they are controlled by the economy.

The following factors can all be controlled by you and your financial decisions. Some may take more time than others, such as raising your credit score or saving up for a down payment.

Credit Score

Your credit score can greatly affect your mortgage rate and the options that you are afforded. Lenders want to see a credit score higher than 740 in order to give you the lowest mortgage rate available or the best possible pricing. If your score is between 700 and 739 your mortgage rate might not necessarily be higher but your costs could.

If your credit score is 699 or below, your interest rate could be higher than someone with a credit score of 700. Mortgage loans for people with a credit score lower than 699 might opt to choose an FHA or VA loan. Consult a licensed mortgage originator or loan officer about which program best fits you.

Mortgage Loan Terms

Opting for a 30-year term vs. a 15-year term will increase your interest rate. Additionally, loans for manufactured homes, condos, second homes, vacation properties and cash-out refinances may have higher rates due to increased risk for the lender. Risk meaning how easy it would be for the mortgage servicer to resell the home if the borrower were to default. This ease of reselling the property or lack thereof is also known as marketability. A duplex is harder to resell than a single-family home and therefore might come with a slightly higher interest rate or closing costs.

Loan-to-Value Ratio

This ratio is calculated by taking the loan amount and dividing it by the total value of the home. For example, if you put down $20,000 on a $100,000 house, your loan amount will be $80,000. This gives you a loan-to-value ratio of 80%.

Any loan-to-value ratio that is higher than 80% is considered more risky for a lender. A higher ratio can affect how low your mortgage rate is as well. The more equity a homeowner has, the less likely they are to default on their mortgage payment.

The more cash you’re able to save for a down payment, the better. If you can get your loan-to-value ratio lower than 80%, this looks really good in the eyes of a lender, and you could potentially qualify for the lowest interest rates.

All scenarios and markets are different. Sometimes a lender might offer better rates and cost to someone with higher than a 80% loan-to-value because the private mortgage insurance helps offset lender risk. A mortgage broker can shop around to different lenders that provide the best terms for your situation.

What is Amortization?

Amortization is when your lender breaks down your loan into a series of payments called an amortization schedule. The schedule shows you every payment that you will be making for the life of your loan. You can see exactly how your loan is broken down and how much of each payment goes to your principal vs. interest.

An amortization schedule is a helpful resource to have on hand. It shows you what your balance is before and after each payment is made. You will also be able to see the estimated payoff date.

The benefit of having an amortization schedule is being able to see your loan as a whole. You can even look at a sample amortization schedule before deciding on your loan terms. For example, looking at a sample schedule may help you determine that a 15-year loan is the best option for you and your family.

Mortgage Rates Forecast

So where are mortgage rates expected to go from here? We entered a recession in early 2020 as a direct result of the COVID-19 pandemic. Economists have called it the worst global economic crisis since the Great Depression.

As we continue to emerge from the recession, mortgage rates will likely start to creep up toward previous levels. The economy is starting to see growth again; we saw a 4% increase in the economy during the last quarter of 2020. Thus far in July 2021, 30-year mortgage rates increased 6 basis points (a basis point is one hundredth of one percent) to 2.949% APR and 15-year mortgage rates went up 6 basis points to 2.285% APR. These rates are an average and not a guarantee, as terms and conditions may apply.

For reference, the 30-year fixed-rate mortgage is 29 basis points lower in July of 2021 than it was in July of 2020.

How to choose the right mortgage lender?

If you are ready to apply for a mortgage, shop around for a lender that offers lower interest rates. You should also check online reviews for any positive and negative feedback about each lender you are considering.

Companies with smaller overhead can often offer the best pricing. Companies spending huge sums of money on marketing typically need to make it up elsewhere.

There are certain questions you should ask your potential lenders before deciding which is the right one to work with.

  • Do you sell your loans?
  • What do you use to determine your mortgage rates?
  • What types of mortgage loans do you offer?

Asking lenders and brokers about rates and types of mortgages will also give you vital information about the services they offer. There are many types of mortgages, but not all of them are right for everyone. Your lender can give you information and resources about each type to help you make an informed decision.

Working With Agave Home Loans

One of the advantages of working with Agave Home Loans is the ability to shop your loan with over 50 different mortgage lenders using a special software program. In general, increased competition and reduced overhead leads to lower interest rates and costs than most other companies.

Click here to apply now!

Marshall spent seven years in hospitality and the restaurant industry prior to beginning a career in real estate and lending. After obtaining a finance degree with an emphasis in investments from Northern Arizona University, he began working at Quicken Loans. He spent seven years there as a banker and then Senior Director prior to co-founding Agave Home Loans. (NMLS ID: #1107208)

Marshall Gottlieb - Co-Owner and CEO
Marshall spent seven years in hospitality and the restaurant industry prior to beginning a career in real estate and lending. After obtaining a finance degree with an emphasis in investments from Northern Arizona University, he began working at Quicken Loans. He spent seven years there as a banker and then Senior Director prior to co-founding Agave Home Loans. (NMLS ID: #1107208)

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