Interest rates are at all time lows, I’m sure you’ve heard. But what exactly is an interest rate? Why does it matter if they’re low? How can you get an interest rate even lower? In this edition of Open House, I’ll address all these common questions and more as you prepare to buy or refinance a home.
What is an Interest Rate?
To put it simply, interest rates are the amount banks charge you to borrow money from them, each year. The amount depends on several factors like the amount of money you’re borrowing, what you’re borrowing it for (as some purchases are more risky or depreciate in value), your credit score, and the going market rate.
Interest rates are put in place as an insurance to pay banks back the money you borrow. They aren’t going to give you money for nothing in return. Since the bank doesn’t know you personally, or know your intentions, they have to protect their investment. That is why there are several factors that make up each person’s interest rate eligibility.
Let’s say you borrow $100,000, and your interest rate is 4%. That means over the life of your loan, you agree to pay an additional 4%, or $4,000 a year, as essentially a “fee” to whomever borrowed you money, usually the bank. This is how interest rates work.
Your mortgage lender will collect several pieces of information from you to determine your creditworthiness. Your interest rate that you get on any loan is based on how likely the bank thinks you are to pay back the loan in full and on time.
Creditworthiness is a combination of items that are used to determine your overall financial health. When talking about mortgages, typical things that are considered are:
- Credit Score
- Length of time in your current job
- Length of time in your current professional field
- Outstanding Debt
- If you’ve previously declared bankruptcy
- If you’ve ever defaulted on a loan or missed loan payments
- Outstanding credit
Each lender has different requirements when determining creditworthiness. One lender might place more of an emphasis on your income while another might pay attention to how much total debt you currently have. They use their scale to in put all your information, check it against the current market rate for mortgage interest rates, and that is how they come up with your personal rate.
That is why shopping around for rates when looking at mortgage quotes can save you thousands of dollars. If you have lower income and a mortgage lender weighs income high on their scale, you might be considered less creditworthy and get a higher rate. Whereas if you present your information to multiple lenders, you can see the different rates you’ll be presented with.
One thing to note is that most lenders won’t tell you their scale, so you don’t know what is more important to them. That is why it’s good to be healthy all around financially.
Locking Interest Rates
Once an interest rate has been quoted, you typically have a certain number of days to lock in your rate. Locking your rate means that you sign a document saying the rate they quoted you is favorable, and you’d like to move ahead with the process of obtaining a loan, but only if the rate is the quoted rate. Because the market for interest rates changes daily, and even the slightest dent or hit to the economy, unemployment, or other factors that influence interest rates can have huge impacts. Locking a rate basically protects you from the rate going up, but can sometimes affect you if the rate goes down. In that case, some lenders will let you reapply for the current rate.
Who Sets Interest Rates?
A lot of people assume The Federal Reserve sets interest rates, but that is not true.
The Federal Reserve System is the central bank of the United States. Although parts of the Federal Reserve resembles some private-sector entities, the Federal Reserve was established to serve the public interest. According to the Federal Reserve themselves, they have 5 key functions:
- conduct the nation’s monetary policy to promote maximum employment, stable prices, and moderate long-term interest rates in the U.S. economy
- promotes the stability of the financial system and seeks to minimize and contain systemic risks through active monitoring
- promotes the safety and soundness of individual financial institutions and monitors their impact on the financial system as a whole
- fosters payment and settlement system safety and efficiency
- promotes consumer protection and community development through consumer-focused supervision and examination, research and analysis of emerging consumer issues and trends
That’s a lot of words to basically say they look at the country and the world to find trends and examples to keep unemployment and inflation low while protecting your money.
Now, like I said, the Federal Reserve doesn’t set rates for things like mortgages. Each bank, or lender, actually set their own rates. But, these rates are based on economic factors like inflation or unemployment, and basically all the same things the Federal Reserve looks at. So, when the Federal Reserve moves their interest rates or outlook on the economy, banks tend to take notice, and action accordingly.
Pandemic Impact on Interest Rates
In the first few months of lockdowns due to COVID-19 in the United States, unprecedented really is the best way to describe the interest rate world, even though I’m as sick of that word as you probably are.
No one had any clue the impacts Covid would have on unemployment and job security, consumer spending, availability of goods, inflation – basically everything that makes up interest rates. To keep the economy as stable as they could when things changed literally by the hour, The Federal Reserve advised that interest rates should be near zero.
This move was made to keep people buying things. Houses, boats, RV’s, anything you might need financed. Mortgage interest rates fell to a record-low 14 times in 2020, an absolutely bonkers thing to think about. This worked, almost too well, as it can be attributed to the tough housing market we’re experiencing today. But that is another story for another day!
What is a Good Interest Rate?
My answer would be 0.0%, but obviously that isn’t very realistic. But, you’d want your rate to be as close to zero as you can get. That is why so many people have rushed into the housing market since rates were dropped. It’s also why so many people have also refinanced their homes. Even the smallest change in interest rate can make a huge impact over the life of your loan.
For example, let’s say you got an interest rate a few years ago at 4.0%. That would historically be considered excellent, as mortgage interest rates have been anywhere from 8% to 3.6% on average in the last 20 years. If you bought a house and the loan amount was $200,000 at 4% interest on a 30 year mortgage, you’d pay $240,000 just in interest. But, lets say you shopped around and found a rate of 3% on the same loan. You’d only end up paying $180,000 in interest over the loan’s life. That small percentage of a difference can make thousands of differences throughout your loan’s life.
There are also different rates based on the term of your loan. Most people are familiar with a 30 year mortgage loan term. That means you have 30 years to pay off the loan in full with interest. There is also a 15 year loan option (among several other year options). A 15 year loan means that you have half the time to pay off the loan as a 30 year loan, making your monthly payments larger. But, the interest rate on 15 year loans is generally at least one if not a couple of percentage points lower. So, you have a lower amount to pay each year and for less years, but your monthly payment will be substantially higher. This is something to think about as well when comparing rates.
One thing I had absolutely never heard of until I bought my house was “buying points”. This is a practice of essentially paying money up front to get a lower interest rate.
Mortgage points, also known as discount points, are fees paid directly to the lender at closing in exchange for a reduced interest rate. When you buy points, you decrease your monthly payment, but you increase the upfront cost of your loan.
One point costs 1% of your mortgage amount. So, if your mortgage is $400,000, 1 point would cost you $4,000. A big distinction to make is that a point does NOT equal an interest rate percentage point. The actual discount you’ll get when you buy a point varies by lender, because as I’ve stated, they’re the ones who come up with the rates based on your creditworthiness. But, generally, for each point you buy you can expect to get .25% interest rate reduction. Points can also be purchased in smaller increments down to ⅛ of a point or .125% of an interest rate.
So, typically, if you are quoted a rate of 3.5% and buy two points, you’re rate would go down to 3.0%.
Should I Buy Points?
So why would you purchase interest rate points? Honestly, not everyone should or needs to. What you have to weigh is the break even point of buying points and if that aligns with your goals.
If you buy a home with the intent of flipping it or only living there a short while, points might not make sense for you. This is because the upfront cost won’t save you money if you pay off the loan in a few years. You really only see savings if you plan to keep the mortgage for a while. Due to the difference in monthly payments, it usually takes 5-10 years to recoup the upfront cost to buy points.
But, for some home buyers, buying points may be worthwhile. For example:
- You need to lower your monthly interest amount to make your mortgage more affordable
- Your credit score doesn’t qualify you for the lowest rates available
- You have extra money and want the upfront deduction
- You plan to keep your home for a long time, so you may recoup the cost
Here’s an example of what buying points will do for a loan at $200,000:
In both cases, you would break even after 68 months, or 5.75 years. Figuring out your break even point will tell you if it makes the most sense for you to purchase points. If you want to be in the home for less time than your break even point, you can always pay more as a down payment or with your monthly mortgage payment!
Still have questions about interest rates? If you would like to talk to a loan specialist, Homes for Heroes has a network with thousands of mortgage specialists waiting to help heroes like you. If you’re a teacher, healthcare worker, current or retired military member, firefighter or EMS, or in law enforcement, sign up to get your questions answered. Once you feel good about your interest rate options, we can also connect you with a real estate agent to help you buy and/or sell a home.
About the Author
Maggie is the Content Manager at Homes for Heroes. She has bought, sold, and refinanced a home and gives her personal views on all three types of home transactions. Her Heroes include her father (teacher), brother in law (veteran), and friends and family in healthcare and law enforcement. She lives in Minneapolis, Minnesota with her husband and two dogs. If you have an idea for an Open House topic, email Maggie here.