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How does a mortgage work?
A mortgage is a loan for the purchase of real estate. A mortgage has a much longer repayment period than a loan for other purposes. Usually, a mortgage has a loan term of 15, 20, or 30 years.
The real estate is owned by the bank throughout the life of the loan and is transferred to the borrower's ownership only after full mortgage payment. Thus, real estate acts as collateral. If the borrower cannot repay the loan and defaults, the bank sells the purchased property and does not lose money. Most often, the borrower must make mortgage payments once a month. By the end of the loan, the borrower will pay the full cost plus interest according to their interest rate.
What affects mortgage rates
Future homeowners are advised to study what factors increase or decrease the mortgage rate. This knowledge will help potential borrowers track changes in mortgage rates and choose the most appropriate moment to take out a mortgage. This is especially true for those borrowers who are aimed at taking an adjustable-rate mortgage since, for this loan, the interest rate varies depending on the state of the mortgage market. Mortgage rates depend on several factors.
Inflation
Inflation erodes the purchasing power of dollars. As of now, the official inflation rate is 6.7% per year. Due to inflation, real estate prices are constantly rising. Mortgage lenders are forced to raise mortgage rates as they must be above the inflation rate so the lender can earn at least some profit by issuing a mortgage. The higher the inflation rate, the higher the interest rate for mortgages banks, lenders, and other financial institutions are forced to set.
The rate of economic growth
Despite inflation, such indicators as the gross domestic product (GDP) and employment rate are growing. This economic growth contributes to an increase in wages and, consequently, to an increase in the purchasing power of the country's residents. People earn more and contribute to the increase in demand for mortgages. Landers, relying on the growth of demand, strive to earn more profit from each mortgage and increase the interest rate. In the opposite situation, that is, if the average income level fell, landers would lower mortgage rates to attract customers.
Federal reserve monetary policy
The monetary policy conducted by the Federal Reserve Bank directly affects the economic situation and the interest rates on loans, particularly mortgages. This organization does not set mortgage rates. However, it sets federal funds rates and money supply adjustments, affecting mortgage market interest rates. A decrease in the money supply leads to an increase in mortgage rates.
The bond market
Banks and investment firms sell mortgage-backed securities (MBSs) as investment products. At the same time, the profitability of such securities should be high to attract buyers. Government bonds and corporate bonds offer competing long-term fixed-income investments. The general state of such a large bond market affects how much lenders charge for mortgages, as lenders must generate high returns to compete in the securities market. This is what provokes the growth of mortgage rates.
Housing market conditions
Housing market trends also affect the interest rate for mortgages. When fewer houses are being built than there are buyers for these houses, lenders increase the mortgage interest rate. The latest market trend, however, has had a downward effect on interest rates. The housing market continues to be unstable as more people prefer to rent a house rather than buy one. For this reason, the demand for mortgages is decreasing, and mortgage lenders are lowering interest rates to attract customers.
How to compare mortgage rates
Comparison of mortgage interest rates is the main comparison that is recommended for a potential borrower to make before taking out a mortgage. Loan terms are usually similar for all loan offers, but the interest rate differs for each lender, since they want to entice customers to themselves.
To make such a comparison, the borrower does not need to open the website of multiple lenders and memorize or write out tons of information while comparing rates. Such analyses have already been carried out, and their results have been published in various Internet sources. Many sites dedicated to financial topics are constantly updating articles about mortgage rates, so it will not be difficult for the borrower to find current indicators on such sites. However, it should be borne in mind that on their websites, lenders often publish the lowest interest rate that they can offer only to a borrower with ideal credit to attract customers.
The search for information in Internet sources can be designated as the primary analysis. To make a more accurate comparison, the borrower should visit the sites of the lenders selected from the first search and compare loan offers. The borrower can find out the real interest rate only after receiving mortgage prequalification from the lender. Usually, online lenders review the application and answer within a couple of hours. Along with a positive response comes the loan agreement, which specifies the rate that the borrower will have if they sign the contract. To find the best interest rate, the prospective homeowner is recommended to get prequalification from at least three lenders, but it is better to have more.
When choosing a mortgage lender with the best interest rate, the borrower should consider that some lenders offer to pay discount points. Discount points, which are also mortgage points, are optional additional fees, and discount points reduce the interest rate for a loan for an additional payment.
Mortgage interest rates trends
According to the latest data from Freddie Mac, today's mortgage rates continue to grow steadily, which has been going on for 6 consecutive months. Currently, the national average interest rate for a 30-year fixed-rate mortgage is 6.7%, which is over 2 times higher than last year's figure. According to Freddie Mac, the situation with a 15-year fixed-rate mortgage is similar. In September 2022, the interest rate for such a mortgage was 5.96% on average, when exactly a year ago, it was 2.15 percentage points. An adjustable-rate mortgage with a term of 5/1 has a 5.3% interest rate, which is 2.8 percentage points higher than last year. Freddie Mac's mortgage rates chart shows that mortgage interest rates show such rapid growth for the first time in the last 4 years.
Such a sharp increase in the interest rate for mortgages has led to the average family being forced to spend about 25% of their income on monthly mortgage payments. Due to the increase in real estate prices and the increase in the interest rate on loans for the purchase of housing, the demand for buying a house is gradually decreasing. According to the forecast from Fannie Mae, by the spring of 2023, the average interest rate for a 30-year fixed mortgage rate will drop to 5.2%, and closer to autumn, it will drop to 4.5%. However, the purchase price for real estate is forecast to remain at the same level. Despite the decrease in mortgage rates, the national average monthly mortgage payment may be higher than expected.
How to get a mortgage with a good rate
When choosing the right mortgage lender with the best interest rate, the borrower should find out the interest rate and the annual percentage rate (APR). APR and interest rates differ because APR includes all additional mortgage costs, including closing costs, loan origination fees, property taxes, private mortgage insurance, and homeowners insurance.
To get the best interest rate for a mortgage, the borrower must ensure their credit score is high enough. The minimum credit score for obtaining mortgage approval averages 620. However, with such a credit score, the borrower can get a high-interest rate up to the maximum possible. If the borrower's credit report is not excellent, the borrower should take the time to improve their credit history before taking out a mortgage. The higher your score, the lower the interest rate you get.
Another important criterion for obtaining a profitable interest rate is a low debt-to-income ratio. The lower this ratio, the better rates the borrower will receive. Ideally, the debt-to-income ratio should not exceed 36%. A borrower's maximum debt-to-income ratio to obtain mortgage approval is 45%. However, having such a high DTI indicator, the borrower risks getting rates higher than expected. An FHA loan is enough to have a DTI in the region of 43%.
The borrower should build up their employment to receive good mortgage rates. Ideally, the borrower should show at least 2 years of stable employment. It is desirable that for all 2 years, the borrower was employed in the same place. The borrower needs to be ready to provide W2s and pay stubs. For the self-employed, the mortgage situation is a little more complicated since lenders have less confidence in them. If the borrower is self-employed, they might need to furnish business records, such as P&L statements, besides tax returns, to round out their application.
An important step to getting a good interest rate on a mortgage is making the correct down payment amount. A larger down payment can help the borrower get a lower interest rate since a smaller loan amount will require a smaller loan term. In this case, the type of mortgage is important. For example, a home loan that the federal housing administration secures (FHA) requires a lower down payment, and a large amount will not be a decisive factor in determining the interest rate.
To maintain a comfortable interest rate for a mortgage, the borrower should take a fixed-rate mortgage. This type of mortgage allows you to have a mortgage rate lock throughout the repayment term. Adjustable rate mortgages allow borrowers to lower their interest rates in the future. However, the interest rate for such a mortgage depends on the mortgage market and, therefore, can both decrease and increase. Here, the borrower shouldn't take risks and choose a fixed-rate mortgage. The borrower should consider a 15-year fixed-rate mortgage because this type of mortgage requires the least interest, although it requires high monthly payments. With such a long loan term, the difference in interest rate between 30-year and 15-year mortgages is noticeable in the total cost of the loan.
To get a favorable loan offer, the borrower should look for ways to refinance the mortgage. Refinancing most often helps borrowers to reduce the interest rate, change the loan term and reduce the monthly payment on the mortgage. The most profitable option for refinancing is refinancing with a 15-year fixed-rate mortgage since this type of mortgage offers the lowest rates, and it allows you to reduce the loan term to 15 years and close the mortgage much faster.