When you decide to take out a loan to purchase real estate, the predominate factor of how much you can borrow will be determined by your payment. In other words, how much you can afford to pay on a monthly basis? The amount of a monthly payment is most heavily influenced by the interest rate on the loan. Even a small change in interest rate can have a dramatic effect on your monthly payments.
For example: a $200,000 loan at 5% equates to a $1074 payment. If you increase the interest rate by just 1%, that same $200,000 loan (at 6%) now has a monthly payment of $1199 – an increase of $125 per month, or $45,000 over the life of a 30 year mortgage.
Now let’s use these same numbers and look at it in terms of how they impact how much home you can qualify for. If interest rates changed from our theoretical 5% to 6% on a $200,000 loan, then to keep your payment at $1074 you would have to reduce the mortgage amount to $179,000 – a decrease of $21,000 in terms of how much home you could buy. A simple increase of 1% on your mortgage interest rate could mean the difference between buying your dream home (or ideal investment property), and having to settle for something less than that.
Now that you understand how big of a difference mortgage rates can make when buying a home, you might be wondering how mortgage rates are determined. Unfortunately there is no one easy answer to that question. It is a tangled and intricate web with multiple contributing factors, which we will discuss here.
There are three main factors that determine interest rates
There are several main factors that mortgage lenders look at to determine your (the borrower’s) credit worthiness. These include your credit score, debt to income ratio and savings or assets. The most important things that you can do to be a good credit risk is to show a consistent history of paying your bills on time, maintain low credit card balances and have credit or trade lines that have been open for a long time. Additionally, lenders like to see healthy savings, retirement accounts or other liquid assets. You can learn more about these factors in our article, How to Get the Best Interest Rate.
The type of home that you are looking to purchase has a direct impact on interest rates. Condominium loans generally carry higher interest rates than single family home loans. Also, non-owner-occupied loans (investment loans) and 2nd home loans are usually associated with higher interest rates and larger down payments. Some homes that were foreclosed on by government institutions such as HUD and Fannie Mae offer special loans with lower, attractive interest rates to new buyers as well.
The other main factors that determine interest rates are largely influenced by the market and economy. Interest rates are typically not set by the banks – this is a common misconception. Instead, interest rates are determined by market conditions.
After a bank makes a loan they will in many cases sell the loan on the secondary market. This secondary market is comprised organizations such as Fannie Mae and Freddie Mac who buy up the mortgages so that the banks can free up more capital to continue making more loans – this helps stimulate a healthy economy.
These organizations then package these loans into mortgage backed securities that people can invest in for a set rate of return. The push and pull between investors wanting higher rates of return, and borrowers wanting a low interest rate, influences the ups and downs of mortgage interest rates.
Interest rates are also influenced by inflation. Lenders pay close attention to inflation, because in times of high inflation the value of today’s dollar is going to be higher than the same dollar in the future when borrower’s actually pay it back. For example, if someone came to you and said I want to borrower a dollar, but I’ll pay you 10% interest on that dollar each year, would you do the deal? Now, let’s say the value of the dollar was falling 15% per year (inflation), would you do that deal now?
Hopefully you said no to the latest deal. You wouldn’t do that deal because the value of your investment would actually be falling every year. The same holds true for mortgage investments, except with a lot more money on the line. If high inflation is projected, it is generally going to cause mortgage interest rates to increase.
These are just a few of the main factors that influence the complex market of mortgage interest rates. In reality there are many more, but at the end of the day they all point back to profits. Lenders are in the business of making money, never forget that. If you are wondering how interest rates are going to be impacted by certain changes in the economy, you can typically refer back to that simple truth.