The Federal Reserve ("The Fed") has raised its benchmark interest rate for the third time in a year to help combat record-high inflation. These changes have sent many borrowers scrambling to get debts subject to interest rate increases paid off quickly. But what about long-term loans like mortgages, how are they affected by The Fed's decisions?
How interest rates are determined
Interest rates are what lenders will charge customers who want to borrow money from them. The actual rate a borrower is charged is dependent on several factors, including:
- Federal Reserve's benchmark rate - This is the base level you can expect to receive, though this is usually lower than the rate you'll get as the lender has additional costs they need to consider.
- Type of loan - Mortgages, personal loans, auto loans, etc., all have different risk factors to consider when determining interest rates.
- Duration of the loan - Short-term loans usually have higher interest rates than longer loans like mortgages.
- Borrowers' (and co-borrowers or co-signers) credit score(s) - The average credit score needed for a mortgage or other loan isn't the only factor lenders will consider when determining your interest rate. The highest scores, or applicants with co-signers with better scores than theirs, will get more competitive rates.
- Down payment - If a down payment is required, your interest rate will be affected based on how much down payment you give. Most mortgages will have around 20% down, though FHA programs will exchange lower down payment requirements for additional Private Mortgage Insurance ("PMI") charges that increase your interest rate.
- Applicants' financial background (job history, assets, etc.) - Those with more stable job histories will have better rates than someone who "job hops" or has periods of extended unemployment.
- The type of collateral given (if secured) - Secured loans will generally have a lower interest because there's collateral given to guarantee the loan. Mortgages use the home as collateral. Since real estate is typically an appreciating asset (it gains value over time), interest rates will stay relatively low compared to other loan types.
What to expect with your mortgage's interest rate
New mortgage applicants should expect a bit of sticker shock with the latest interest rates, especially compared to the last few years. Throughout the COVID-19 pandemic, interest rates for all types of loans were near historic lows. Unfortunately, as demand began to outpace supply, inflation rates began to rise, causing prices of goods and services to increase.
To combat this, The Fed began to enact a series of benchmark rate increases to rebalance supply and demand. The more expensive it is to borrow money, the lower demand for loans which in turn allows supplies to increase.
Consequently, when The Fed raised rates to combat inflation, it created a ripple effect across all lenders that touched credit cards, personal loans, and mortgages.
For those currently in fixed-rate mortgages, you shouldn't expect to see any interest rate increase. Those with variable-rate mortgages, however, should expect notification of rate increases in their mailboxes soon.
New mortgage applicants should expect significant increases even from last year's rates.
While the record-low rates in 2020 aren't coming back soon, there is still hope for more competitive rates soon.
How to get a better mortgage interest rateImprove your credit score - Regardless of market conditions, the easiest way to ensure you get the best rate possible on any type of loan is by getting your score above 720. While the minimum credit score needed for a home equity loan or mortgage is much lower, the lower the score, the higher the lender considers the risk and will adjust your interest rate accordingly.Offer a higher down payment - This might be easier said than done, but your interest rate will decrease if you can get a down payment that removes a PMI requirement.Shop around - Mortgages are one of the most popular products for lenders, so there are always promotional offers. Check online for the best rates before settling on one.Wait a little - Rates will stabilize and decrease as the housing supply increases, so if you can wait a few months, you might see lower rates soon.
The bottom line
While The Fed's rate increases will impact the price of homes, it's important to remember that not all mortgages are created equal. Apply for a loan that best suits your needs, and be patient as rates adjust towards more reasonable levels.
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