Most property buyers have eventually come across mortgage rates or mortgage interest rate, but where do they come from? Mortgage rates are the interest rates charged on a mortgage, which is the most common type of loan used to buy real estate. This loan is secured by real estate; thus, if the borrower defaults the payment, the lender can take his property, making it a relatively safe loan for the lender as long as the loan amount is lower than the value of the property.
Why should buyers care about mortgage rates?
The mortgage rate represents how much it costs each month to finance a property’s loan; therefore, people must be conscientious when choosing the loaner because a small difference in the monthly fee will add up, and at the end of the loan, it will represent a much higher cost.
Therefore, consumers may wonder how they can lower these rates. To understand how, it is essential first to analyze the components that affect the mortgage rates.
Type of Interest Rate
Mortgage rates can either be fixed or variable. Fixed rates do not change until the mortgage’s maturity, eliminating the volatility risk of an increase in the interest rate. It also allows the borrower to be prepared for future payments since the monthly principal and the interest payment will remain constant. However, if the interest rates decrease exponentially, the borrower may secure that lower rate by refinancing the mortgage. Due to this extra risk the lender is taking, the longer the fixed deal, the higher the rate is likely to be.
On the other hand, if borrowers believe that interest rates will fall over time, to take advantage of those lower rates without the need for refinancing, they will choose a variable-rate mortgage or an adjustable-rate mortgage (this model is a hybrid, initially has a fixed-rate period and after that a variable rate). In this type of home loans, the interest rates are not fixed; instead, they will be adjusted at a level above a specific benchmark or reference rate, such as the EURIBOR or U.S treasuries. The amount that the borrower pays above the benchmark is called spread, and it represents the gain that the lender will obtain.
Credit scores
Probably the most critical factor that impacts the interest rate is the investor’s credit score. This indicator evaluates the consumer’s creditworthiness based on his credit history: number of open accounts, total levels of debt, repayment history, and other factors. Mortgage lenders use this score to determine if the borrower is qualified to receive the mortgage and his risk of defaulting the loan’s payment.
Therefore, a high credit score means that the default risk is low and the person has shown responsibility for previous credit obligations. Consequently, he will be qualified to receive the loan, and the interest rate will be lower, which means a lower total amount to pay for the house.
Conversely, a low credit score represents a higher risk for lenders since the probability of borrower defaulting is much higher. Thus, it will be harder to get qualified to receive the loan, and if it is, the interest rate will be much higher than one with a high credit score. This will eventually lead to a significant increase in the total amount paid by the house.
The trade-off between points and interest rates[i]
In addition, another factor that influences the mortgage rate is the swap between interest rates and “points”. Points or Discount Points are fees that the borrower pays up front in exchange for a lower interest rate over the loan’s life. This is also called “buying down the rate,” which will reduce payments over time.
It is important to note that this is optional, so each investor has to analyze the best option.
Down payment
A down payment is the payment of part of an asset’s purchase price that must be paid upfront that is not borrowed and usually comes from each investor savings. In this case, it is the payment of a portion of the value of the property. Even though they are not always necessary, most banks require a certain percentage of down payment for the house. In Portugal’s case, unless the property is being sold by the bank, the down payment is generally 10% of the property’s price. Despite this, the borrower can always make a higher down payment, which is recommendable since the bigger the percentage paid upfront, the smaller the loan contracted which can significantly decrease the interest rate.
How the economy is impacting mortgage rates?
After observing how mortgage rates can be impacted by the investor’s profile and the loaner negotiating process, it is also essential to analyze how these rates have evolved throughout time and how economic variables impact them.
As we can observe in this graph, mortgage rates have shown us a downwards trend over the years, showing historic lows, both in 2012 and 2020. Both years were critical for the international economy. The year 2012 represented the market’s downfall peak from the Financial Crisis, and during 2020, the economy suffered a significant impact from the current pandemic crisis. Despite this correlation not being coincidental, mortgage rates are impacted by several economic factors:
• The level of economic growth: Generally, when the economy shows signs of economic growth, consumption and wages increase, leading to an increase in mortgage loans. This high demand results in high mortgage rates since banks only have as much as they can lend;
• Inflation: When there is an increase in the price of goods and inflation rises,mortgage loaners may suffer a reduction in their real net profits over time. This is why, when establishing these rates, loaners must consider eventual fluctuations, so they do not get jeopardized;
• Housing market conditions: The overall conditions of the market also affects mortgage rates. If there is low investment in the economy and the propensity to buy houses is low, interest rates will naturally decrease. Also, trends such as the preference for renting over buying may, as well, be a factor;
• The bond market: Due to mortgage-backed securities traded by banks and other financial institutions, the bond market conditions have an impact on the establishment of mortgage rates. Actually, bond prices have an inverse relationship with mortgage rates; as bond prices go up, mortgage rates go down;
• Federal Reserve/ Central Banks monetary policy: Despite the Federal reserve not controlling mortgage rates, it is responsible for establishing Fed Fund Rates and adjusting money supply for governments and financial institutions such as banks. This impacts interest rates available for the borrowing public.
After understanding how economic variables shape mortgage rates, we can now analyze how they are generally affecting loaning.
In Portugal, the average annual interest rate was 0,957% in 2020, Portuguese mortgage rate fell to less than half in ten years. This preceding year was the first-ever that Portugal presented an average mortgage rate inferior to 1%. This can be justified mainly by the reduction of the interest rates (from the ECB), which currently presents negative values, and by the reduction of Spread since banks have been reducing their commercial margins.
Another interesting case to observe is Denmark. This country has the longest history of negative Central bank interest rates. The Nordea Bank Abp is providing 20-years loans with 0% fixed-rates, while other Danish banks are also announcing it.
As the European’s and Danish’s, most Central Banks worldwide are decreasing their interest rates to negative values (or slightly above 0% in some cases) due to low inflation, to propel the economy, and to reduce regular banks’ interest rates. As a consequence, mortgage rates are decreasing, making it easier to have access to mortgage loans.
Conclusion
As we can see, many external and internal factors can influence the conditions of the loan. It is vital to observe the current economic juncture to evaluate the risk and the loan’s conditions. Besides this, it is crucial to be aware of the characteristics and factors here presented since negotiation is essential for the investor to get the mortgage interest rate which better applies to his situation.
[i] May not be applicable to some banking systems
Authors: João Miguel Rodrigues and Miguel Mendes
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