Mortgage Rates FAQ’s

Mortgage Rates Have you ever wondered what caused mortgage rates to move up or down?  Read through our Mortgage Rates FAQ’s to understand what drives your mortgage rate.  Also, learn more about a variety of other topics related to the interest rate on your mortgage.

How are mortgage rates determined?

• 10-Year Treasury and Its Risk-Free Rate: Changes in the 10-year Treasury yields are considered to be the best indicator for mortgage rates.  Most mortgages are paid off or refinanced around the 10th year and that makes the risk-free 10-year Treasury a comparable benchmark.  Treasury yields are always adjusted for inflation expectations and thus mortgage rates take into account any inflation factor as well.  Mortgage rates move in the same direction as yield on the 10-year Treasury though they may not move by the same percentage points every time.

• Investors’ Risk Premium on Mortgage Rates: Investors who buy mortgage backed securities often require a risk premium on top of the risk-free rate of the 10-year Treasury yield to account for the borrower’s default risk and earlier repayment risk.  Mortgage backed securities are financial instruments that are made up of hundreds or even thousands of individual mortgages.  When yields on mortgage-backed securities are traded in the market, the prevailing yields are reported back to banks, which use these yields to determine the prevailing mortgage rates offered to borrowers.

• Supply/Demand Pressure on Mortgage Rates: In good economic times, mortgage supply from mortgage borrowers increases and demand for mortgage-backed securities from investors decreases because of other competing investment opportunities in a good economy.  Whenever mortgage supply exceeds the demand of mortgage backed securities, mortgage rates tend to increase.  When the demand for mortgage backed securities exceeds mortgage supply, mortgage rates tend to decrease.  This occurs because the interest rates on mortgages have to reflect the relative demand for these products.  If there is a supply / demand imbalance mortgage rates to increase or decrease to make mortgages or mortgage backed securities more or less attractive relative to other investments, thereby, always finding an equilibrium point where mortgage supply will equal mortgage backed security demand.

What is an Annual Percentage Rate (APR)?

An annual percentage rate (APR) is a percentage rate that takes into account the annual cost of a loan, including interest, insurance, origination fees, and other costs associated with obtaining a loan expressed as a percentage.  A loan’s APR is an important metric to understand because the APR provides the borrower with a better measure of the true cost of a loan.  The APR enables a borrower to compare different loans that have the same mortgage rate and to determine which loan will actually cost the borrower more money because of other fees that are not included in the base mortgage rate. 

For example, you might get the following two quotes for $150,000 mortgages, each for a 30-year term:

• Lender A offers 6.50% with the borrower paying no discount points and $5,000 in fees;

• Lender B offers 6.25% with the borrower paying 1 discount point ($1,500) and $5,500 in fees, for a total of $7,000 in points and fees.

Lender B offers a lower interest rate (or “nominal rate”), but for $2,000 more in points and fees.  Lender A’s offer has an APR of 6.83%, while Lender B’s offer has an APR of 6.71%.  Since Lender B’s APR is lower, that loan is a better deal in the long run.

Although APR’s do help consumers compare various mortgage options, there are limitations to this metric.  In the example above, Lender A’s offer might be better in the short run while Lender B’s offer might be better in the long run.  Lender B’s offer carries a lower APR, but you, the borrower, have to come up with $2,000 more in cash.  What if you don’t have the money, or you have it, but need it to buy appliances?  In those cases, you might prefer the first loan, despite its higher percentage rate and APR.

What if you think you might move within a few years?  Loan A costs $948.10 a month in principal and interest — $24.52 a month more than Loan B.  So with Loan B, you pay $2,000 up front to save a little less than $25 a month.  At that rate, it takes 82 months — more than 6.5 years — to recoup the $2,000. If you sell the house in less than 82 months, Loan A costs less.

Another problem with APR calculations is that it is not always clear which costs are included in the calculation.  As a result, different lenders will include different costs into its APR calculation that can lead to an understatement or overstatement of the true cost of the loan relative to other lenders.

Overall, a loan’s APR is a good tool to help compare various loans as long as you consider the drawbacks and limitations associated with its calculation and interpretation.

How are Annual Percentage Rates calculated?

Let’s look at how APRs are calculated.  For our illustration we will assume the following: 

• Loan Amount: $150,000
• Mortgage Rate: 8.50% fixed rate
• Term: 30 Years
• Monthly Payment: $1,153.37.
• Discount Points: 1.50% or $2,250.00
• Appraisal Fee: $275.00
• Credit Reporting Fee: $50.00
• Other Lending Fees: $500.00

In order to calculate the APR for this loan we subtract $2,250.00 (1.50 points), $275.00 appraisal fee, $50.00 credit report fee, and $500.00 other lender fees. ($150,000 – $3,0750 = $146,925).  The $146,925 is then used as the present value/loan amount to determine the true cost of this loan.  Using a financial calculator and solving for the new interest rate for a $146,925 loan with the same payment of $1,153.37, the APR is calculated as 8.73%.

How does this compare to a 30 year fixed rate loan with a 8.00% interest rate and 3.50 points? The monthly payment for this loan is $1,100.65. In order to calculate the APR for this loan we subtract $5,255.00 (3.50 points), $275.00 appraisal fee, $50.00 credit report fee, and $500.00 other lender fees. ($150,000 – $6,075 = $143,925). The $143,925 is then used as the present value/loan amount to determine the true cost of this loan.  Using a financial calculator and solving for the new interest rate for a $143,925 loan with the payment of $1,100.65 the APR is calculated as 8.44%.

What factors affect your mortgage rate?

• Credit Scores: Your credit history is collected by 3 different credit bureaus.  When you make an application for a home loan, the lender will get a credit score from each of the three credit bureaus.  Most lenders use the median (numeric middle of the 3) as the score with which they will underwrite your loan.  The higher your credit score, the better your credit grade.  Most of the mortgage products on the market usually have a higher rate for lower scores and a lower rate for higher scores.

• Loan-to-Value Ratio (LTV): How much money are you putting into the transaction for the down payment?  Most traditional loan products that offer the most aggressive rates require at least a 5% down payment on the mortgage.  When you get a mortgage that requires a small down payment, your mortgage rate will be adjusted higher to account for the lower level of equity that you will have when you purchase your home.

• Debt-to-Income Ratio (DTI): Traditional underwriting guidelines require very specific documentation to prove your income.  That income must be enough so that your DTI is somewhere between 40% and 50% of your gross monthly income.  Typically, no more than 40% to 50% can go to your new housing payment and all of your other monthly debts.  However, many borrowers today don’t meet this guideline for various reasons.

• Escrow Account: Traditional mortgages require that the lender set-up and maintain an escrow account to save and pay for your home owner’s insurance and property taxes.  However, many borrowers would rather manage those funds themselves.  In many cases, not utilizing an escrow or impound account may result in a slightly mortgage rate.

• Time to Close: Interest rates are usually locked for 15, 30, or 60 days. The longer your lock-in period, the higher the interest rate will be.

• Who is paying your closing costs: Many borrowers have a limited amount of funds available to use in the purchase of their new home.  What many do not consider is that the closing costs have to be paid in addition to the down payment.  There are 3 options available to pay closing costs : (1) You can pay them yourself out of pocket.  This is normally the lower rate option.  (2) You can negotiate the seller to pay part or all of them for you.  You will still get the lowest rate but the cost of the house will likely go up.  (3) Your lender can pay them for you and build these costs into a higher interest rate.

• Loan Program: The longer the loan term, the higher the rate (15 year, 30 year, 40 year, etc.).  Fixed rates are higher rates than Adjustable Rate Mortgages (ARMs).  The longer the ARM fixed period, the higher the rate (3/1 ARM, 5/1 ARM, 7/1 ARM, etc.).  If you add an interest only option, your rate will be higher. There are a number of other loan options that could add to the interest rate.

• Loan Size: The rates change depending on the size of your loan.  The best rates available are for loans between $100,000 and $417,000.  Smaller loans typically have higher rates to offset the relatively fixed costs for processing, underwriting, and closing your loan.

What is a rebate or lender credit?

A rebate, often also called a lender credit, is a credit to the borrower by the lender for taking an interest rate higher than the zero point rate.  When a borrower chooses to accept a higher interest rate, the lender is able to offer the borrower a credit or rebate to offset the borrower’s closing costs.  The lender hopes to recapture the rebate amount paid by collecting a higher interest rate over the life of the loan.  Also, the lender may receive more money from the sale of a loan that has a higher interest rate, which enables the lender to rebate some money back to the borrower. 

Receiving rebates for loans is a very common practice as it can significantly reduce the amount of closing costs required.  This is especially helpful if the borrower does not have a significant amount of liquid cash assets to pay for both the down payment on the home and closing costs, which can add up to an additional 3-5% of the loan amount.

Borrowers can use rebates or lender credits to offset any non-recurring closing costs, including the guaranteed lender fee, appraisal, closing agent, title insurance, recording and/or transfer taxes.  Rebates may not be used to offset prepaid expenses, such as prepaid interest, initial escrow/impound account deposit or homeowner’s insurance premium.

Should I pay points to obtain a lower rate?

Paying points may or may not be your best option, depending on what you’re doing.  Points paid on a loan you’ve refinanced can be deducted from your taxes only in small increments-1/30th a year for a 30-year mortgage, for example.  This means it could take many years before your lower rate makes up for the points you pay.  However, if you’re buying a home, points paid are a tax-deductible expense for that year.  The best way to decide whether you should pay points on a loan is to perform a break-even analysis.  This is done as follows: 

1. Calculate the cost of the points. Example: 2 points on a $100,000 loan is $2,000.
2. Calculate the monthly savings on the loan as a result of obtaining a lower interest rate.  Example: $50 per month.
3. Divide the cost of the points by the monthly savings to come up with the number of months to break even.  In the above example, this number is 40 months.  If you plan to keep the house for longer than the break-even number of months, then it makes sense to pay points; otherwise it does not.
4. The above calculation does not take into account the tax advantages of points.  When you are buying a house the points you pay are tax-deductible, so you realize some savings immediately.  On the other hand, when you get a lower payment, your tax deduction reduces!  This makes it a little difficult to calculate the break-even time taking taxes into account.  In the case of a purchase, taxes definitely reduce the break-even time.  However, in the case of a refinance, the points are NOT tax-deductible, but have to be amortized over the life of the loan.  This results in few tax benefits or none at all, so there is little or no effect on the time to break even.

If none of the above makes sense, use this simple rule of thumb:  If you plan to stay in the house for less than 3 years, do not pay points. If you plan to stay in the house for more than 5 years, pay 1 to 2 points. If you plan to stay in the house for between 3 and 5 years, it does not make a significant difference whether you pay points or not!

What is an interest rate lock?

A lock-in, also called a rate-lock or rate commitment, is a lender’s promise to hold a certain interest rate and a certain number of points for you, usually for a specified period of time, while your loan application is processed.  (Points are additional charges imposed by the lender that are usually prepaid by the consumer at settlement but can sometimes be financed by adding them to the mortgage amount.  One point equals one percent of the loan amount.) Depending upon the lender, you may be able to lock in the interest rate and number of points that you will be charged when you file your application, during processing of the loan, when the loan is approved, or later. 

A lock-in that is given when you apply for a loan may be useful because it’s likely to take your lender several weeks or longer to prepare, document, and evaluate your loan application.  During that time, the cost of mortgages may change.  But if your interest rate and points are locked in, you should be protected against increases while your application is processed.  This protection could affect whether you can afford the mortgage.  However, a locked-in rate could also prevent you from taking advantage of price decreases, unless your lender is willing to lock in a lower rate that becomes available during this period.

It is important to recognize that a lock-in is not the same as a loan commitment, although some loan commitments may contain a lock-in.  A loan commitment is the lender’s promise to make you a loan in a specific amount at some future time.  Generally, you will receive the lender’s commitment only after your loan application has been approved.  This commitment usually will state the loan terms that have been approved (including loan amount), how long the commitment is valid, and the lender’s conditions for making the loan such as receipt of a satisfactory title insurance policy protecting the lender.

When should I “lock in” an interest rate?

A loan lock is an agreement issued by a mortgage lender to the consumer guaranteeing to fund a loan at an agreed upon interest rate and points even if rates or fees go up at the time the loan is disbursed.  When deciding to lock a loan, there are 3 points to consider: (1) Interest rate, (2) Points, and (3) Length of the lock period. 

• Borrowers will pay extra for an extended loan lock.  It’s not free. The interest rate will be a bit higher or the points will reflect the loan lock fee.  That’s because the lender is taking on the risk that rates could go up while the transaction is processed, so the lender could end up losing money if the loan is funded at a lower-than-market interest rate.

• Nobody can predict where mortgage rates will go.  Historically, rates rise faster than they come down.  If you are thinking about buying a home or refinancing your mortgage, it is often advantageous to lock in your rate as soon as possible as you can always refinance later your loan later if rates drop again.  Any near-future drop in interest rates may not be drastic enough to meaningfully impact your monthly mortgage payment.  Also, locking in a loan as soon as possible can provide borrowers with peace of mind against potential increases in rates.

• There is rarely a reason not to lock a loan.  Interest rates change daily, sometimes hourly.  To protect yourself against the volatility of the marketplace, it’s a good idea to lock your rate once you are satisfied with the rate.  The reason some buyers dislike loan locks is because they want to grind every dime out of a transaction that is humanely possible.  Remember that if the rate was acceptable when it was locked three weeks ago, a drop of an 1/8 of a point or so isn’t the end of the world.

How long are lock-ins valid?

Usually the lender will promise to hold a certain interest rate and number of points for a given number of days, and to get these terms you must settle on the loan within that time period.  Lock-ins of 30 to 60 days are the most common.  Typically, the longer the period, the greater the fee. 

The lock-in period should be long enough to allow for settlement, and any other contingencies imposed by the lender, before the lock-in expires.  Before deciding on the length of the lock-in to ask for, you should find out the average time for processing loans in your area and ask your lender to estimate the time needed to process your loan.  You’ll also want to take into account any factors that might delay your settlement.  These may include delays that you can anticipate in providing materials about your financial condition and, in case you are purchasing a new house, unanticipated construction delays.  Finally, ask for a lock-in with as few contingencies as possible.

What happens if a lock expires?

If your loan does not close within the lock­in period, you may lose the interest rate and the number of points you had locked in.  This could happen if there are delays in processing whether they are caused by you, others involved in the settlement process, or the lender.  For example, your loan approval could be delayed if the lender has to wait for any documents from you or from others such as employers, appraisers, termite inspectors, builders, and individuals selling the home.  On occasion, lenders are themselves the cause of processing delays, particularly when loan demand is heavy. This sometimes happens when interest rates fall suddenly. 

If your lock-in expires, most lenders will offer the loan based on the prevailing interest rate and points.  If market conditions have caused interest rates to rise, most lenders will charge you more for your loan. One reason why some lenders may be unable to offer the lock-in rate after the period expires is that they can no longer sell the loan to investors at the lock-in rate.  When lenders lock in loan terms for borrowers, they often have an agreement with investors to buy these loans based on the lock-in terms. That agreement may expire around the same time that the lock-in expires and the lender may be unable to afford to offer the same terms if market rates have increased.

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