Granted, there are several ways that mortgage rates are determined. However, for the purposes of this article, we are only going to review 3. It is my belief that a review of 3 ways is sufficient enough to answer the teething question: ‘How are mortgage rates determined? We are going to look at the fixed rate mortgage, the adjustable rate mortgage (ARM), and the PITI that is included in each mortgage initiated. PITI is an acronym that stands for principal, interest, taxes, and insurance(s) that are included in most mortgage payments.
A fixed rate mortgage is a loan that has an interest rate that remains the same over the length of the loan. The rate is determined by the secondary market. The secondary market is the place where bonds and securities, including those backed by mortgages, are traded and sold.
The health of the market is the major indicator of where the interest rate will be set. There are other factors that influence this rate, as well. When the economy is poor the rate will hover around 4.5%. When the economy is good, the rate can go as high as 6%. The lender will add their margin to this rate, which becomes their profit.
If you select a repayment term of 15 years you will have a lower rate of interest than a note that matures in 30 years. The lender receives money back faster with the shorter note and the borrower pays a higher payment. The lender also can offer a 10 year note and a 20 year note, but these are rare.
Another mortgage option is the adjustable rate mortgage (ARM) which has an interest rate that fluctuates over time. You may pay the same rate from the initiation of the mortgage until several years have passed. At a pre-scheduled interval your lender will recalculate your rate of interest using current interest rates. Your payment will go up or down depending on the current rate of interest compared to the rate you paid at loan initiation.
Lenders use several indexes to determine the new rate of interest. Some of these are called LIBOR, Constant Maturity Treasury, and Bank Bill Swap Rate. Sometimes lenders don’t use these indexes, but choose to calculate their own rate. An ARM can be adjusted at any time that was set forth in the original contract.
Some can be changed each quarter, some each year, and others have a period of up to five years before the rate is adjusted. Each ARM will have a percentage cap on the rate increase that is used with each adjustment period and will also have a lifetime percentage cap.
If you have a fixed rate mortgage or an ARM or one of the other types that we haven’t covered in this article, you will still have other charges that you will pay with the monthly repayment. The acronym PITI is used in the industry to represent the money allocations included in each mortgage payment.
First, you will determine the amount of the payment that is allocated to principal and to interest. These are the figures that will be used to repay the lender for the funds borrowed. The principal and interest are the first two figures referred to in the acronym PITI.
The next initial stands for the taxes you will owe annually for property taxes. The final initial is for insurance. There are two insurances primarily associated with home ownership. One is the hazard insurance that all lenders require the home owner to have.
This insurance will protect the lender’s investment if the home is damaged or destroyed by fire, theft, and other catastrophic events. The second insurance that may or may not be required is private mortgage insurance. This is insurance that will benefit the lender if the buyer defaults on the mortgage.
A lender will total the PITI charges and determine the percentage of your total income that will be allocated to the payment. The lender will also add your total debt payment to other loans to include with this total. Your utility bills, home maintenance, and other expenses will all be included. The lender expects the total of all these expenses, along with the mortgage payment, to not exceed 36% of your total income.
You can calculate these figures for yourself to determine the amount you can afford to pay for a home. You can manage the mortgage loan process by shopping for a home that you already know you can afford. If you want a home that is more expensive than you qualify for, then you need to pay your debts before you apply for a mortgage loan.
There you have it. I want to trust that now you have a rough idea of how mortgage rates are determined and that you are better informed when you go for a mortgage the next time!