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How mortgage rates work and how to lock a better interest rate

Mortgage Rates

Mortgage rates are the interest rates assigned to a home loan, which is commonly known as a "mortgage". Mortgage rates are based on the price of mortgage-backed securities (MBS), which are bonds backed by U.S. mortgages. Mortgage rates vary between conventional, FHA, VA, USDA, and jumbo loans; and, by mortgage lender.

How Mortgage Rates Are "Made"

Huge numbers of U.S. consumers research mortgage rates every day. Most just want a ballpark figure to help do the math on what buying a home would cost, or to see what a home refinance would look like.

Others prefer personalized mortgage rates - especially when they're close to making a decision about what to do next.

To everyone, though, getting a good, low rate is paramount. A mortgage is not something on which you want to overpay. Imagine paying "too much" on the most valuable asset you own; and, for the next 30 days.

This is why it's important to understand how mortgage rates are "made".

When you have a feel for how mortgage rates are made and how mortgage rates work, you can put yourself in a better position to shop for the lowest available rate with the best closing costs possible.

What Is A Mortgage Rate?

Did you ever wonder where mortgage rates come from?

Mortgage rates are "made" based on bonds traded in the mortgage-backed securities (MBS) market. Similar to corporate bonds, mortgage-backed bonds trade all day, every day.

MBS pricing changes constantly.

In general, as the price of a mortgage-backed bond changes, so do mortgage rates. This is true for conventional mortgages backed by Fannie Mae and Freddie Mac mortgage bonds; and for FHA loans, VA loans and USDA loans, which are backed by Ginnie Mae mortgage bonds.

The price of a mortgage bond is based on supply and demand. All things equal, when Wall Street's demand for mortgage bonds increases, mortgage bond prices rise which causes mortgage rates to fall.

Mortgage rates and MBS prices move in opposite directions.

Demand for mortgage bonds can change for a multitude of reasons, but the most common driver of demand is risk-avoidance. Most mortgage-backed bonds are guaranteed by the U.S. government, therefore, they're considered "extra safe".

Default risk is practically nil with U.S. government-backed debt.

During periods of economic or political uncertainty, then, U.S. mortgage bonds tend to be in high demand. It's trading pattern is known as a "flight-to-quality" and it's a fairly common one.

When there's a bona fide flight-to-quality going on, consumer mortgage interest tend to drop.

Mortgage rates will often move in the same direction, but not always in equal measure.

Also, sometimes, mortgage rates are subject to "adjustments"; price changes made by the agency which secures the bond.

For example, with Fannie Mae and Freddie Mac, mortgage interest rates on a 2-unit property are higher than for a single-unit home (e.g.; a detached home). This is because owners of 2-unit homes are more likely to default, historically.

Fannie Mae and Freddie Mac also change mortgage rates for borrowers based on their credit scores. In general, the lower your credit score, the higher your mortgage rates.

These sorts of adjustments are known as "loan-level pricing adjustments". They're akin to middleman fees and they reflect the added risk of a particular mortgage loan trait.

Things That Don't Control Mortgage Rates

Mortgage rates are based on the price of mortgage-backed securities and, aside from loan-level pricing adjustments, there are no other direct forces on U.S. mortgage interest rates.

This distinction is important.

For example, here are some things that don't control mortgage rates.

The 10-Year Treasury Note Doesn't Control Mortgage Rates

It's commonly said that mortgage rates follow the path of the 10-Year Treasury Note. This is not true.

The 10-Year Treasury Note is a debt-issuance from the U.S. Treasury and, over time, the 10-year note and mortgage-backed bonds will trend together; but, on any given day, the two can diverge.

Therefore, you can't watch the yield of the 10-Year Treasury Note and know in which direction mortgage rates are moving with certainty.

One of the reasons why people like to say that mortgage rates track the 10-year is because access to real-time MBS data is expensive whereas data on the 10-Year Treasury Note is as close as turning to CNBC.

For real-time mortgage rates, you'll need to watch MBS pricing.

The Federal Reserve Doesn't Control Mortgage Rates

This means that the Federal Reserve's primary policy tool - the Fed Funds Rate - is also unlinked to mortgage rates.

The Fed Funds Rate is the overnight interest rate at which banks borrow money from each other. It's an interest rate fixed by the Federal Reserve and used to change the speed at which the U.S. economy expands.

If the Fed Funds Rate was linked to current mortgage rates, there would be a linear relationship between the two.

Instead, the Fed Funds Rate and the conventional 30-year mortgage rate have differed by as much as 500 basis points (5.00%) over the last 10 years; and by as few as 50 basis points (0.50%) over the same period of time.

Congress Doesn't Control Mortgage Rates

And, lastly, mortgage rates aren't set by Congress, or any other elected U.S. official.

The rhetoric and actions of our nation's legislators can affect demand for mortgage-backed securities worldwide; and, can change how loan-level pricing adjustment are used, but their influence remains indirect.

Mortgage rates move at random.

How To Be A Good Mortgage Rate Shopper

Mortgage rates move randomly, and change with little or no advance warning. When you're shopping for a mortgage, then, it's important to know the tricks - and also to have a plan.

You have to shop "right way".

This means remembering that shopping for a mortgage rate is really about shopping for a mortgage rate and its associated closing costs. You can't get one without the other.

A mortgage lender will never quote you a rate without telling you the fees that go with it so pay attention when you get your quotes - a rock-bottom rate means nothing if your closing costs are astronomical.

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