If you’re in the market to purchase or refinance a home, you’re probably being exposed to a whole range of information the average person doesn’t think about on a routine basis. You’re looking at mortgage rates, but how are they set anyway? What is it exactly that mortgage investors like Fannie Mae, Freddie Mac, and the VA do? Finally, after your loan closes, what the heck is mortgage servicing?
How Are Mortgage Rates Determined?
When shopping around for mortgage rates, there’s probably a temptation to think lenders set these things pretty arbitrarily. However, there are actually two big facets to determining the interest rate on a mortgage: market conditions and your personal financial profile.
How Base Interest Rates Are Set in the Market
There are a few different market factors that affect interest rates for mortgages. In addition to the day-to-day activities of mortgage bond traders, the Federal Reserve also plays a role.
The Role of the Federal Reserve
In its original mandate from Congress, the Federal Reserve was set up to be the central bank of the United States. This means it has a variety of responsibilities, including overseeing banks as a whole and setting certain financial policy regulations. Perhaps the most important role it plays from a consumer perspective is in the setting of short-term interest rates.
When the Fed’s Open Market Committee (FOMC) meets to determine what this benchmark interest rate should be at any given time, they have a couple of key goals:
- Achieving maximum employment
- Maintaining staple prices
The Fed has a bit of a balancing act here because those goals sometimes run in competition with each other. To achieve the highest possible rate of employment, you might choose to keep interest rates low, because cheaper borrowing can stimulate businesses to invest. This can lead to more hiring as well as more money spent on goods and services, which can have a knock-on effect and help still more business prosper.
However, if the cost of borrowing funds it too low, this also tends to mean that the money you have saved in the past is worth less than if higher borrowing costs made funds scarcer. If your money isn’t worth as much, prices can go up quickly, as you need to part with more money to get the same amount. Pretty soon you end paying $15 for a loaf of bread.
It should be noted that a little bit of inflation can be a good thing, since the threat of rising prices can encourage people to buy now rather than wait for some undetermined date in the future, stimulating economic activity. But it’s important for the Fed to keep a thumb on the scale. Recently, the target goal has been 2% inflation per year.
The Fed must do its best to maintain an equilibrium between these two factors when it sets the benchmark short-term interest rate, which is the rate at which federally insured banks can borrow money each night. The range of short-term interest rates currently sits between 2.25% – 2.5%
Although the most immediate impact may be felt in the rates for shirt-term lending – credit cards, personal and auto loans – longer-term payoffs like mortgages tend to correlate with these short-term rates. Depending on market factors the base interest rate for a mortgage might run between 2%-3% higher than short-term rates.
