How are mortgage interest rates set?
Rather than tailoring mortgage interest rates to each borrower’s financial situation, lenders use uniform interest rates across the entire housing market. While some borrowers may receive slightly better interest rates for an excellent credit rating, the base and limits on interest rates result from macroeconomic factors and the functions of governing bodies, such as the Federal Reserve.
In the US economy, the market sets interest rates. However, the Federal Reserve (the Fed) – our nation’s central bank – balances market forces by influencing the amount of money in the economy.
For example, the Fed controls the discount rate, that it takes on the loans that it grants to banks and other financial institutions. The Fed resets this rate every 14 days to reflect trends or fluctuations in the economy. The discount rate is the only rate that the Fed directly controls.
Prime is one of the most common standards for credit card and home equity line of credit rates. It correlates with the federal funds rate, which the Federal Reserve controls. The prime rate is about 3% higher than the federal funds rate, which banks charge each other when they lend money to one another.
The percentage increase exists because lenders view consumer loans as riskier than loans to other companies. That said, a mortgage is less expensive than other consumer loans because if a borrower defaults on their mortgage, the lender can repossess the home.
Transcendent economic factors will always play an important role in available mortgage interest rates. However, a borrower’s financial situation will influence the interest rate a lender will ultimately offer.
For example, a borrower’s credit score will affect the final interest rate offered by a lender. A credit score of 670 or higher will reduce the interest rate on the mortgage. The higher the credit score, the better the discount.
Also, your lender will consider your debt to equity ratio (DTI) when offering you a loan. This calculation is based on your monthly debt payments divided by your monthly income. The upper limit of your DTI is usually 43%. A DTI of 35% or less can earn you a reduced interest rate.
Finally, your income and assets help the lender determine how likely you are to pay off your mortgage. Borrowers with large excess cash, investment accounts, and real estate have greater financial capacity than borrowers with meager bank accounts and no assets.