How are home loan rates determined?

A common question I hear from my clients is if a drop in the Fed rate will lower the home loan interest rates. The short answer is no, in fact home loan rates tend to fall prior to a Fed rate cut and rise after it is announced. That leaves the question of exactly what affects the interest rates on consumer home loans. The answer is no where near straight forward.

The Process

Before we can look at loan rates we need to understand the flow of money in the home loan process. When you apply for a loan the mortgage broker shops around and finds a primary lender that has a program and rates that fit your needs. That primary lender processes your loan and pays the seller for the home you are purchasing. Now the primary lender can either hold your loan and collect the interest you pay, or they can sell your loan to the secondary market which is what commonly happens. The primary purchaser of home loans in the United States is Fannie Mae. They purchase loans with particular requirements from primary lenders, allowing the lenders to turn around and make more loans. Loans can also be bundled and sold to open market as mortgage backed securities which is commonly what happens to loans that don't conform to Fannie Mae's standards. Once the loan is sold, the primary lender has cash to go out and make new loans to home buyers. This cycle is what operates the home loan industry in our country.

Risk/Marketability

Because the vast majority of home loans are sold to Fannie Mae or as mortgage backed securities the level of risk attached to your loan greatly affects your home loan rate. Your credit score, loan to value, type of loan, and even geographic area influence the best rate possible for your loan. In essence, the lower the risk that you will default on your loan, the lower your interest rate. Higher risk buyers will be charged higher interest rates to offset the increased default risk. Federal Funds Rate The Federal Discount Rate that we hear so much about, has little directly to do with your home loan rate! The Federal Funds Rate is the price of very short term loans that banks pay to borrow money from the Federal Reserve Bank. This in turn influences the rate that banks charge to loan money to each other and from which banks set their prime lending rates. The Wall Street Journal Prime Rate is the most widely quoted measure of the prime rate. It is a survey of 30 of the largest lenders and changes when three-quarters of them adjust their prime rates. This index is commonly used as a reference for credit cards, home equity lines of credit and adjustable rate home loans.

The Fed Rate for home loan investors is one of the indicators of how well the economy is doing. Home loan rates are market driven, and if investors feel that the economy is doing poorly, rates fall, and if it is heating up and will experience inflation, rates will climb. There is no set index or number that your home loan is tied to. Home loan rates move and flux and can change several time through out the day. So if your loan officer says 'lock your loan now' you may want to do it right then.

Putting it All Together

From this it should be starting to be clear that it isn't the Fed that sets your home loan rate, but rather the investors that ultimately will be buying your loan, even though they will never know who you are personally. It is their estimation of the economy in general combined with the market demand for loans that actually sets the home loan rate at any one moment. This is a great reason to establish a relationship with a trustworthy mortgage broker and check in with them from time to time regarding what the loan market is doing.

Your Best Bet

If you are pondering buying a new home, then it will likely not be in your best interest to try and time out the home loan market. You should talk with your loan officer and talk to them about your situation and needs in comparison to what loans are currently available. It is much more profitable to put time into improving credit scores, improving debt to income ratios and building up your down payment, as those will all improve the class of loan available to you. Refinancing a home gives more opportunity for timing rates, and if you have an adjustable rate loan, or a fixed loan that has too high of an interest rate, you may find that refinancing is a good idea. Talk with your loan officer about what programs are available, and what they expect loan rates to be doing in the near future.

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