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The Science of Mortgage Rates

How Do Mortgage Rates Work?

What Are Your Rates?

On almost a daily basis I receive calls from people interested in purchasing or refinancing their home and the conversation generally starts with “What are your interest rates”. While this would seem to be a very simple question, as you will see it is a much more complex question than what it would appear to be.

What I would like to show you is what steps are involved in answering this question properly. While rates are one important factor in deciding whom you will be doing business with, another thing to consider is the expertise and integrity of the person with whom you chose to employ.

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There are many loan factors that affect the overall pricing of a mortgage rate such as Occupancy (Owner Occupied or Rental Property), Type of Home being financed (Single Family Residence, Condominium, Mobile Home), Loan Term (15 year, 20 year, 30 year) and Loan Type (Fixed Rate, Fixed/Adjustable Rate, Adjustable Rate, Interest Only).

There are also borrower factors that can affect pricing such as Qualifying Credit Score and Loan to Value (How much is being borrowed versus the value of the collateral).

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How Mortgage Rate Quotes Can Lie

As a mortgage professional concerned with providing the highest level of service possible to those I work with, finding a way to have this initial conversation can be difficult. Pricing is a conversation best had once all the critical information has had the chance to be reviewed but not providing an answer at the beginning can result in you losing the opportunity to be of service. Trying to take advantage of this opportunity to educate your client on how pricing works can overload the person asking this simple questions with too much information all at once.

I believe this is a conversation that must be had, but we need to make sure it is discussed within its proper context. Your quoted interest rates are not secured until they are “Locked In”. Until the interest rate has been locked, the overall pricing will continue to be affected (positively or negatively) by market fluctuations. The purpose of “Locking” an interest rate is to insure the quoted interest rate can be delivered on the loan documents.

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Locks are generally secured for a period of 30 to 45 days. This means that the proposed loan must be completed and funded before the expiration date of the interest rate lock. If for some reason the loan has not been closed within the lock period, there is generally a cost required to extend the Lock date. These cost may vary depending on the additional amount of time needed to close the loan.

This is what makes providing a “quick” answer so dangerous and why you may not receive the rate you hear on the radio when you actually go through the lending process (listen to the disclaimers on those advertisements).

The decision to lock the interest rate must be done at the proper time to avoid potential additional costs to extend the interest rate lock. The challenge is that the costs associated with interest rates can change throughout the course of any business day so your initial interest rate discussion can vary when it becomes time to have the lock conversation.

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It is important to note that current lending laws require lenders to have a standard pricing model applicable to all clients. Charges for loan services cannot vary from client to client so there should never be a scenario where your pricing has changed just to increase the profits of the lender you are dealing with. Any changes should just be the result of overall market fluctuations.

How Does Interest Rate Pricing Work?

To answer this question, we will look at two different scenarios. It is important to note that you can have any interest rate you would like, it simply becomes a function of how that decision effects your loan request. Below is an example of a Rate Sheet which would be used to determine pricing. This is where your interest rate quote begins:

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30 Year Rate 15 Day Base Cost/Credit 30 Day Base Cost/Credit 45 Day Base Cost/Credit
3.875% (1.625%) (1.500%) (1.250%)
4.000% (2.500%) (2.375%) (2.125%)
4.125% (3.250%) (3.125%) (2.875%)

**Cost/Credit adjustments are based on Loan Amounts**

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Fannie Mae has “Loan Level Pricing Adjustments” that must be applied to this rate sheet to determine the overall price of the interest rate selected.

In the first scenario, we will be using the following assumptions:

  • New Home Purchase: $300,000
  • Property Type: Single Family Residence
  • Qualifying Credit Score: 685
  • Loan Program: Fannie Mae Conventional 30 Year Fixed
  • Loan to Value: 80% (Loan Amount of $240,000)
  • Lock Period: 45 Days
  • Required Fannie Mae Adjustments due to Credit Score/Loan to Value: 1.750%

The overall pricing of the requested loan would work as follows:

The 3.875% rate has a 1.250% Credit for its base rate. We must subtract from that the required Fannie Mae adjustments of 1.750%. This would leave us with a .500% Cost to produce that interest rate ($1200).

The 4.000% Rate has a 2.125% Credit for its base rate. We would subtract from that the required Fannie Mae adjustments of 1.750%. This would leave us with a .375% credit that can be used to reduce the closing costs associated with the loan closing ($900).

The 4.125% Rate has a 2.875% Credit for its base rate. We would subtract the required Fannie Mae adjustments of 1.750%. This would leave us with a 1.125% credit that can be used to reduce the closing costs associated with the loan closing ($2,700).

As you can see, the interest rate you select can greatly affect the total loan closing costs. If you have limited funds to apply towards closing costs, an increased interest rate can help lower them if needed. If overall costs are not a concern or your seller is crediting funds towards closing costs, you can look to buy down (pay for) the lower rates. Interest rate credits can only be used to pay towards closing costs. They cannot be used to contribute towards any required Down Payment.

In the second scenario, we will explore how the property type can affect pricing. We will use the same basic assumptions except that we will now assume we are buying a condominium and that we have a 720 Qualifying Credit Score.

  • New Home Purchase: $300,000
  • Property Type: Condominium
  • Qualifying Credit Score: 720
  • Loan Program: Fannie Mae Conventional 30 Year Fixed
  • Loan to Value: 80% (Loan Amount $240,000)
  • Lock Period: 45 Days
  • Required Fannie Mae Adjustments Due to Credit Score/Loan to Value: .750%

Required Fannie Mae Adjustments Due to Property Type: .750%

How Lender Credits Work

The 3.875% Rate has a 1.250% Credit for its base rate. We must subtract from that the required Fannie Mae adjustments of 1.500%. This would leave us with a .250% Cost to produce that interest rate ($600).

The 4.000% Rate has a 2.125% Credit for its base rate. We must subtract from that the required Fannie Mae adjustment of 1.500%. This would leave us with a .625% credit that can be used to reduce the closing costs associated with the loan closing ($1500).

The 4.125% Rate has a 2.875% Credit for its base rate. We must subtract from that the required Fannie Mae adjustments of 1.500%. This would leave us with a 1.375% credit that can be used to reduce the closing costs associated with the loan closing ($3300).

What you may have noticed is that the required Fannie Mae adjustment for Credit Score/Loan to Value is the second scenario was much lower. This is a great example of how maintaining your credit profile can lead to reduced costs whenever you borrow money.

About Your Expert

Rick Kent

With almost 20 years in the mortgage industry, I specialize in seeing the opportunities that many other lenders miss. The experience I have attained over the years is worthless if I cannot share it with others. If I can help answer any mortgage questions or help you reach your goals of homeownership, I am always willing to help.

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