Owning a home is one of the greatest financial commitments that one may complete in life. Conservative homebuyers typically prefer fixed-rate mortgages, which charge the same interest rate throughout the duration of the loan term, in order to easily budget around regular housing payments. Before applying for fixed-rate mortgages, it is critical for buyers to understand the interest rate environment. From here, effective home buying strategies can be executed.
Secured Loans and Collateral
Mortgages are secured loans – with your real estate serving as collateral. Terms of the mortgage contract specify that the lenders can foreclose upon property and auction it off to make good on any missed payments.
For banks, these collateral provisions reduce financial risks, and allow these institutions to offer relatively low interest rates. Alternatively, credit cards are examples of unsecured loans. The bank lends out of good faith and receives nothing when borrowers default on credit card debt. Banks charge high interest rates on credit card loans as compensation for taking on more risks.
Fixed-rate mortgages typically mature in either 15 or 30 years. 30-year fixed-rate mortgages feature higher interest rates – because financial risks increase with time. With an additional 15 years, you have more opportunities to lose your job, get divorced, or suffer from an illness that impedes your ability to make payments.
Inflation risks also increase with time, as a rising price level erodes the purchasing power of future mortgage payments for banks. The 15-year mortgage product does offer relatively low rates. A 15-year mortgage, of course, subjects buyers to higher monthly payments because the loan amortizes over a shorter period of time. Online mortgage calculators can be important budgeting tools.
The Federal Reserve Board
The federal funds rate is a benchmark, or comparison standard, for fixed mortgage rates. Banks make loans to each other overnight at the federal funds rate – so that each financial institution can meet its Federal Reserve requirements. For their mortgage offerings, each bank charges a premium above the federal funds rate, as compensation for taking on more risks of dealing with consumers instead of other financial institutions. The Wall Street Journal publishes daily charts and commentary that compare the federal funds rate to national mortgage rates. The interest rate environment is synonymous with the “cost of money.”
Low mortgage rates often signal recession. The Fed lowers rates to combat an economic slowdown and encourage people to take out loans, invest money, and spend cash on big-ticket items. When the economy recovers, the Fed will drive federal funds and mortgage rates higher to guard against inflation. Higher interest rates discourage investment and consumption, which then works to stabilize the price level. Current homeowners should still continue monitoring the interest rate environment, in order to better refinance existing mortgages into newer loans at lower rates.
Banks analyze the strength of applicant personal finances before setting interest rates on a fixed mortgage. To secure a good rate, homebuyers should target a monthly mortgage payment that is less than 30 percent of their monthly gross income. Total debt payments, including mortgage, credit card, and automobile notes, should also be less than 36 percent of gross income. According to Bankrate.com, a credit score above 760 provides applicants with access to the most competitive mortgage rates.