Understanding Mortgage Interest Rates

Mortgage interest rates have been a hot topic for a while now. From the unprecedented historically low rates in 2020 and 2021, to the rate increases in 2022 and 2023, interest rates have been a major factor for potential homebuyers in deciding to make a move or not.

So, what exactly is an interest rate, what factors affect rates, and what can you do to get the best rate when you are ready to buy a home?

What is a mortgage interest rate?

In the simplest of terms, an interest rate is the cost you will pay to borrow money. When you take out a mortgage to buy a home or property, you agree to repay the lender the loan amount  (the principal) as well as interest. The interest rate is expressed as a percentage. In general,  the lower your interest rate, the lower the cost of borrowing.

Mortgage rates vary based on several factors. Freddie Mac began tracking mortgage rates in 1971 and since then, the median 30-year fixed mortgage rate is approximately 7.41%. However, rates reached an unprecedented record low of 2.65% in January 2021 and has been as high as 18.63% back in October 1981. The interest rate, however, does not reflect all charges associated with borrowing. Therefore, a more accurate picture of your loan cost is the annual percentage rate, or APR.

What’s the difference between the two?

The annual percentage rate reflects the total cost of borrowing money. The APR, also expressed as a percentage, includes the interest rate, points, fees, and any other charges.

Types of Interest rates:

Interest rates can be fixed or variable. The interest on a fixed-rate mortgage will remain constant for the entire loan term. Loan term refers to the length of the repayment period. Common fixed-rate terms are 15 and 30 years.

If you obtain a 30-year fixed rate mortgage, the APR in year one of repayment would be the same as in year 30. But it is important to note that while your APR and monthly payment doesn’t change, the amount of interest you pay each month does change. Over time, a greater portion of the monthly payment will be applied to the principal and less to interest. This is known as amortization.

A loan with a variable rate is known as an ARM (adjustable-rate mortgage). With an ARM, you have an initial fixed rate for a set period and then the rate will adjust either up or down annually depending on market conditions which are tied to a benchmark interest rate called an index.

For example, a 3/1 30-year ARM has a fixed initial rate for the first three years of the loan and then adjusts once a year for the remaining  27 years. A 7/1 ARM has an initial rate for the first 7 years and then adjusts every year for the remaining 23 years. The advantage of an ARM is that the introductory rate is typically lower than the average fixed-rate mortgage which can make the monthly mortgage payments more affordable initially. This type of loan may work well for someone who does not plan to own their home long term and want to take advantage of the lower initial rate.

Factors that influence rates:

At the macro level, rates are influenced by economic conditions like inflation and employment trends, and actions taken by the Federal Reserve to adjust monetary policies and current economic growth.

But for an individual borrower, the interest rate you qualify for is determined by your creditworthiness, debt-to-income ratio (DTI), down payment amount, property value, loan program and loan term.

Tips to get a more favorable interest rate:

It is important to do a little leg work before you apply for a mortgage to ensure you get the best rate possible for your financial situation. Here are some tips:

KNOW YOUR NUMBERS!

Typically, borrowers with stronger credit profiles will secure a lower interest rate. That’s because a borrower with a good or very good credit score and a positive credit history is seen as lower risk to the lender compared to someone with a poor credit history. Therefore, it is best practice to know what your credit score is and what is on your credit report BEFORE applying for a loan.

A credit score is a three-digit number that represents your credit risk. This score falls into one of 5 categories, which are Poor, Fair, Good, Very Good and Excellent. Scores of 300-579 are considered Poor and scores of 800-850 are Excellent. Most borrowers have credit scores that fall between Fair and Good. According to Experian.com, the average credit score for American consumers was 714 in 2022.

Your credit history is a record of how well you have managed your debt. This includes a detailed account of how many credit accounts you have opened and for how long, amounts owed, whether you pay your bills on time, how much debt you have, missing and late payments, how many times you’ve applied for credit recently, and if you have any liens, bankruptcies, foreclosures or civil suits and judgments.

The three main credit report agencies most lenders use are Equifax, Experian, and TransUnion. By law, you have the right to a free credit report once a year from each of these agencies. You can get a free copy of your credit report by reaching out to each agency individually or by visiting www.annualcreditreport.com to request from all three at once.

Checking your credit report at least once a year will allow you to identify inaccurate or incomplete information, catch fraudulent activity, know what lenders see and be able to dispute any errors.

PUT DOWN A LARGER DOWN PAYMENT

Conventional mortgages only require 3% of the loan amount for a down payment, but if you can put 20% down, you not only avoid paying Private Mortgage Insurance (PMI) but also improve your chances at getting a more favorable rate.

UTILIZE POINTS AND BUYDOWNS

If you can’t put 20% down or are just looking for a lower rate in general, buying discount points or utilizing a buydown may be right for you.

Points are a way to “pay down” your interest rate by paying extra money upfront to lower your interest rate and therefore, decrease your monthly payment. Each point cost 1% of the loan and will lower your interest rate up to 0.25%. That may not seem like much, but it could save you thousands on interest. Paying points reduces the rate for the entire life of the loan.

Buydowns are a temporary reduction to your interest rate. Buydowns will reduce the rate for the first couple of years. There are a couple buydown options available, but one example is a 3/2/1 buydown. This means the first year, your interest rate will be reduced by 3%, year two by 2% and reduced by 1% in the third year. The cost for this reduction is paid upfront when you obtain the loan. MiMutual Mortgage offers both seller paid and lender paid buydowns.

OPT FOR A SHORTER LOAN TERM

A shorter loan term will typically come with a lower interest rate. Why is that you may wonder? This is because interest rates reflect risk of default and opportunity costs. The longer the repayment period, the more time a borrower could potentially default. Also, the longer a lender has the principal (the loan amount) tied up, the longer that money cannot be used for other purposes (opportunity cost). Therefore, a 15-year mortgage will have a lower interest rate than a 30-year mortgage.

TALK TO A LOAN OFFICER EARLY

Most importantly, one of the best ways to ensure you will get the best rate and loan option available for your financial situation and homeownership goals is to talk to a Loan Officer as early as possible in your home buying journey.

Talk to a Loan Officer even if you don’t plan to buy a home for at least 12 months. Planning ahead improves your chances of getting the best rate and term possible! Your Loan Officer will be able to review your overall financial health and address any issues in advance, develop a strategy to get the lowest rate possible, present options you may not have known about and offer step-by-step guidance from pre-approval to the closing table.

The Key Takeaway

Interest rates play a major role in the overall cost of homeownership. Even a small change in the interest rate can significantly impact your monthly payment and the total amount of interest paid over the life of the loan. While there are several ways you can improve your chances of getting the best rate, working with a Loan Officer even before you are ready to make a move can be most beneficial. Also, bear in mind, that interest rates fluctuate (remember the rate in 1981 vs 2021?) so while it is important to get the best rate you can when you obtain a loan, there is always an option to refinance to a lower rate when rates drop. Interest rates are unavoidable when borrowing money, so it is worth it to do your homework and understand the real costs of the loans or credit before you accept.