Interest Rates

Nine Factors that affect Your Interest Rate?

  1. Risk

    • We receive a credit report from Experian, Trans Union, & Equifax to determine Risk Assessment. This report provides an overview of your body of credit.

    • Your credit scores are a numeric representation of risk as defined by the mortgage model your credit is applied through, (credit history, balance of accounts, length of accounts, percentage of usage of credit accounts, late payments, judgements, liens, collections, etc.). 

    • The more favorable your risk appears, the lower the interest rate.  

  2. Property Type

    • Different Single family Residence

    • Condo

    • Manufactured Home

    • Unique Homes such as Cabins, Underground Homes, etc.

  3. Home Usage

    • Primary Residence, 2nd Home, or Investment Property.

    • Your better rates will be for a Primary Residence.

  4. Loan to Value

    • The percentage of down payment to the purchase price affects your rate.

    • Different loan options require different minimum down payments.

  5. Loan Type

    • Conventional, FHA, VA, USDA, Jumbo, Non-traditional, etc.

    • Interest Rates varies by the loan type.

  6. Investor Appetite

    • The market wants better risk loans. For example, in today’s market, Fannie Mae and Freddie Mac want 700's+ credit for better rates.

    • For Investor specific loans such as Non-QM loans, the investor dictates specifically the loan requirements and interest rates.

  7. Margin

    • Lenders have a margin included in their interest rates. Some are cheaper than others. We position ourselves to be competitive.

  8. Rate Lock Period

    • With everything equal, a shorter lock rate term such as 15-days would provide a lower interest rate, than a longer lock term such as 90-days.

    • We can lock rates 6-months in advance of the closing, but you pay for that security with a higher rate.

  9. Points

    • Clients can receive a lower interest rate than the standard PAR Rate by paying points. For explanation and examples, please call me to discuss.

Good News! I shop your rate to assure you receive a competitive rate no matter what your credit score is; the loan type chosen; or lock period needed. Thank you! Ray

 

Interest rates...can be thought of in three ways.

1. Required Rate of Return: this is the minimum amount of return an investor is willing to receive when making an investment.

2. Discount Rate: the rate used to determine the present value of future cash flows. When you loan someone money with the intention of being paid back in the future, you must place a value on how much of a premium you are losing by not spending that money right now. The discount rate is essentially how much you are charging to delay repayment until a future date.

3. Opportunity Cost: the value an investor passes up when choosing an alternate investment. You must earn enough interest when you loan someone money to compensate for the loss of income that you could have been earning by investing elsewhere.

All interest rates are determined relative to what is considered to be the real risk free market interest rate if no inflation were expected in the future. This real risk free interest rate, which most consider to be the 90 day US Treasury bill, is the benchmark for how other market rates are determined. Unfortunately, the majority of interest rates are not risk free; there are other factors that go into determining what the money you invest NOW will be worth in the FUTURE. This is the concept of "The Time Value of Money". 

When placing a present value on your future cash flows you must consider several risks…these risks correspond to what you expect to receive in return from investing funds. That said, going back to how interest rates are determined.  Remember all rates are based off of the "risk free" benchmark interest rate. On top of that, to compensate for unexpected and expected risks, investors will demand additional returns based on the following…

1. Inflation Premium: If you invest $10 today and you expect the value of a dollar to be worth less tomorrow, then logically you would expect to be compensated for the loss of the principal investment. More simply if you expected your money to be able to buy less of a good or service in the future, you would expect to be compensated for the lack of consumption. If you were considering lending money or investing and inflation was a concern, you would demand a higher rate of return (interest rate) to compensate for the loss of purchasing power.

2. Default Risk Premium: this portion of an interest rate is based off of the possibility that the person or company you are lending money to may not be able to pay you back. For instance, if the borrower went bankrupt.

US Government Bills, Notes, and Bonds have a low default risk premium because they are backed by the full faith and credit of the United States Government.

On the other hand…. subprime mortgage loans have a higher default risk because there is a higher probability that those borrowers may default on the loan. So the lender demands the borrower pay a higher interest rate to compensate for the added risk. 

3. Liquidity Premium: If an investment cannot be easily turned back into COLD HARD CASH it is said to be illiquid.

The liquidity premium is based off the market's demand for the specific type of debt (bond) you hold or are attempting to issue. There is massive demand for US debt (bills, notes, and bonds) …if you wanted to sell your holdings of these securities it would be easy to find a buyer.

However, if you hold the debt of non-public company, it would likely be harder to find a willing buyer of that debt because of a lack of transparency regarding the firm’s financial well-being. When it is hard to find a willing buyer, the seller must lower the price enough to attract buyers. This is said to be an illiquid security.

4. Maturity Premium: This compensates an investor for not spending their money today. Since most prefer to have a dollar today instead of a dollar tomorrow (because you can invest today and make money today as opposed to waiting until tomorrow…TIME VALUE OF MONEY!!!), the longer funds are lent for, the more the lender will demand to compensate them for the lost time value of money.

Furthermore, the longer the length of the loan (longer maturity) the more time there is for economic conditions to change. That means that, given a longer time frame, all of the previously discussed premiums have a higher likelihood of being worse (or better) at the time of maturity. For example, inflation expectations may change or the ability of the debt issuer to service their loan may be lost…and your investment will be worth less.

This explains why the yield curve of US Treasury bills, notes, and the bond is generally sloped upward. The clarity of economic expectations defines the maturity premium.

So to put all this together…Interest Rate = real risk-free interest rate + inflation premium + default risk premium + liquidity premium + maturity premium

Rates change daily, therefore, we do not guarantee a rate until it is locked. This can be done anytime within 6-months of closing at your request.  The shorter the rate lock period, (with all factors being the same), the lower your rate will typically be.  Most clients lock their interest rate within 45-days of closing.

We Shop Rates for You

We shop your rate for you with 12+ investors, such as Wells Fargo, SunTrust, Franklin America, Citi, PRMI, Chase, US Bank, and others.  By doing so, we assure that the rate offered is competitive. 

When should You Lock

I recommend locking as soon as you are comfortable with the rate/payment, keeping in mind current market conditions.  For example, if the experts are recommending to wait and watch rates for a possible improvement, rates may still go up.  That said, by locking you may miss out on rate reductions which would lower your monthly payment.

Protection for You

Once your rate is locked, if rates increase, you are not affected.  What if rates drop?  If the market improves 3/8th or more your rate automatically floats down to the lower rate. If the market improves less than 3/8th, your rate remains as locked. 

What if the Rate Expire

If we lock your rate but there is a delay in closing...and your rate expires, there is a daily fee for extending the rate.  This is rare since most closings happen on time, however, there could be a delay for various reasons such as:  waiting on title, repair completion, builder/seller issues, etc.

Did You Know

You can get money by accepting a higher interest rate!  This is a strategy many clients use if they need money to close for expenses.  It may be a good strategy anyway if you are not staying in the home long.  Another option is to buy the rate down.  With record low interest rates, this is typically not done, however, if you are planning on staying in the home long term, it may be worth considering, if you have available funds.  We will discuss all options.

What is MBS? What is Securitization?

MBS or "Mortgage-Backed-Securities" are what groups of similar loans turn into in order to be sold, bought, and traded.  This process of turning loans into securities is known as "securitization."  Securitization, though not without its risks, is largely beneficial for all parties involved, and is currently essential to maintaining availability of mortgage credit (ability of consumers to get a loan if they want one).  It also helps rates stay lower than they otherwise could be, on average.

The two basic building blocks of a mortgage-backed-security are the CONSUMER who wants to borrow money (a mortgage, in this case), and an INVESTOR that wants to lend money in order to earn a return on investment.  No matter what you've heard about MBS, Fannie, Freddie, FHA, and other government programs, MBS cannot and will not exist without consumers who want to borrow and investors that want to lend. The remaining facets of mortgage securitization grow from those two building blocks.  

How do investors benefit?  

Investors want to lend, but they also want to be protected from risk.  If one investor with $200k only made one loan to one consumer, and that consumer defaulted, that investor would shoulder the burden of the entire loss.  

Even if that investor has $1 million, and makes 5 loans for $200k, depending on the rate of default, the investor could easily experience a very different rate of return than another investor with the same amount of money investing in the same kinds of loans.

Naturally, if the investor was a gifted underwriter with a perfect eye for risk in assessing potential borrowers, he or she could greatly reduce the risk of default for his or her investments.  Lenders attempt to do this anyway, but even if we factor out underwriting standards and the loan process, securitizing loans into MBS reduces risks for investors.

Reducing Risk.  Risk is reduced because securitization allows it to be "spread out" among similar loans.  Consider the hypothetical scenario for an investor:

- Average loan amount: $200k

- Default Rate = 1 in 20 loans

- Loss per default = $50k

This investor has a 1 in 20 chance of losing $50k for every $200k they lend.  If 20 investors each made one of these loans, 19 of them would be profitable and one of them would be out of business.  They need a way to share this risk equally!

If Investor A and Investor B can afford to make 20 loans each, chances improve that actual defaults will match the anticipated default rates, but even if the default rate is accurate, Investor A could be holding both of the loans that default while Investor B holds none.  These two investors STILL need a way to share risk equally!

Securitization accomplishes this goal of risk-sharing.  It allows both of the investors in the example above more certainty as to the default rate.  It's a trade-off between the small chance of big losses and a near certainty of small, predictable losses.  Investors will take the certainty every time because if they can reliably predict the risk, they can easily adjust the price to account for that risk.

In the example of 20 investors each making 1 loan of $200k, if they "pool" those 20 loans together, and if the advertised default rate holds true (1 in 20), then they'll have only one $50k loss divided amongst them ($2500).  In this way, the investor has traded the 5% chance of a $25% loss for 100% chance of 1.25% loss ($200k x 1.25% = $2500).  Knowing that the 1.25% loss is coming makes it easy to adjust the price so that the lender is profitable and can stay in business.  

Conclusion on Securitization

Securitization is helpful for several reasons.  The greater the certainty with which lenders can predict losses, the smaller the margins can be that protect against losses.  This translates directly into lower rates for consumers.  

Securitization also means investors can buy a piece of a mortgage portfolio without financing every mortgage in it.  This is akin to buying stock in a company rather than the company itself, and it allows for far greater participation in the mortgage market among investors.  More participation makes for a more liquid market where buyers and sellers can be relatively more assured of finding other willing buyers and sellers near current prices.  This also reduces margins in the secondary mortgage market, incrementally benefiting rate sheets.

Of course there are downsides to this model.  One might argue that the level of detachment between investors and the loans in which they were investing in the run-up to the financial crisis was one of reasons for the crisis.  Indeed, it would be hard to argue otherwise, but the benefits of securitization (much more liquidity in mortgage markets, more loans for more people, lower rates, and less risk for investors) will likely be seen as outweighing the costs (detachment masking the real risk of loss, borrowers having to fit the underwriting mold of housing agencies) for the foreseeable future.

 Simply put, MBS = "Mortgage Rates."

There's no exact formula for deriving lender rate sheets from MBS price movements, but there's also no question that MBS price movements affect lender rate sheets above all else.  The reason for this is conceptually simple: If MBS are the market-based securities that mortgage loans turn into, then MBS prices represent what an investor is willing to pay for a group of a certain type of loans at a certain interest rate.  Therefore, when the price of a particular MBS changes, so does the VALUE of any loan that fits in that particular MBS "bucket."

MBS Movements are early indicators of lender reprice risk

Although MBS prices aren't the only consideration for lenders when formulating rate sheets, any significant change in MBS prices will almost always correspond to a similar change in prices on lender rate sheets.  For instance, if the price of a particular bucket of MBS had been holding steady all morning and then suddenly dropped by half a point, there is now half a point less compensation available in the secondary market for any loans falling into that bucket.  That means that a lender who funds a loan and plans to sell it will now make half a point less on that sale, and though the exact amount and timing varies by lender, that half point is generally going to come right out of that lender's rate sheet.

MBS Prices change hundreds, sometimes thousands of times a day.  Because of this, it's not practical for lenders to publish new rate sheets every time prices change.  Instead, most lenders will wait until prices are a certain amount higher or lower than those that prevailed when they formulated their initial pricing for the day.  There are other considerations and habits vary by lender, but all lenders are beholden to MBS Prices as they represent the real-time VALUE of the loans that lenders are originating.  This leads us to the following conclusion:

·        IF we know that changes in MBS Prices must eventually affect the rates that lenders can offer

·        IF we know that lenders cannot and will not simply change rate sheets in real time as MBS Prices change

·        IF we can observe MBS Prices change in real time and we know how those changes should eventually relate to pricing

·        THEN: We can reasonably predict when lenders may begin changing rate sheets before they've had time to change them

Indeed, many originators seek out live MBS Pricing/Alerting systems in order to lock loans before a negative price change.  While this can certainly save money on individual transactions, it's not the highest and best use of this knowledge.  In fact, beating the buzzer on a reprice isn't the "us vs them" struggle between originators and secondary it might seem to be at first glance.  It's actually all about managing risk and managing counterparty expectations.

Additional Concepts

How are MBS Different From Treasuries?  

Keep in mind when we're working with MBS, we're not working with something as mechanical and simple as a regular old 'bond.'   While MBS are part of 'bond markets,' there's a reason they're not called "mortgage bonds."  

The important difference between MBS and Treasuries is that MBS are backed by mortgages that determine how investors are repaid.  Treasuries are back by the US Government's full faith and credit.  The principal amount is fixed, as are the payments from day 1.  

MBS payments get progressively lower as principal is paid down and as loans are paid off due to refinances and purchases of new homes.  This introduces a major subjective consideration into determining the value of MBS, and attempting to determine, with accuracy, how many loans of a certain initial quality will default, how fast they'll refinance based on certain movements in interest rates, and how enticed they might be to sell the home associated with the mortgage in this pool of MBS, is BIG BUSINESS for the firms that participate in the secondary mortgage market.  

All of the above introduces a measure of risk and uncertainty that cause yields of MBS to trade at a premium to the essentially risk-free Treasury yields.  It's pretty simple: investors are taking on more risk with MBS, so they require more yield in order to buy them versus something less risky.  

This concept can be a bit tricky, but it's also usually the first significant "light bulb moment" when someone begins to learn about MBS.  Take time now to internalize it as it will serve as a valuable foundation for future lessons.  

Why is it valuable to understand the relationship between the two?  

Because it helps us understand where rates come from!

Even if you are already well aware that mortgage rates are not based directly on US Treasuries, most people are not!  In fact, even many financial professionals incorrectly believe that US Treasuries dictate mortgage rates.  The power to explain why this isn't the case will REALLY set an originator apart from the competition.

But Treasuries and MBS usually move in the same direction, right?

Right!  That certainly lends to the misconception that mortgage rates are based on Treasuries, because it's absolutely the case that movements in Treasuries INFORM and set the pace for mortgage rate movement.  But if we go back to the concepts we just discussed about how pools of mortgages act as collateral for MBS, then we could see quite simply that mortgage lenders (who are in the business of selling those pools of mortgages) will have their COST OF FUNDS determined by the PRICES that investors are willing to pay for those pools of mortgages!  Otherwise known as MBS!

In other words, mortgage rates move based on ebbs and flows in investor demand for mortgage debt.  That demand literally dictates what it costs lenders to make mortgages and that cost is factored in with lender-specific considerations (like overhead, margins, etc) to determine what goes on the rate sheet.

It just so happens that the investors buying agency MBS view them as a supplementary investment in a fixed-income portfolio.  They're not quite like Treasuries, but they're still guaranteed by entities that are in the conservatorship of the United States government.  In practice, the repayment of principal and interest of MBS is virtually risk-free.  (Note: There is indeed virtually no risk that a lender won't be repaid either by the underlying pool or by Fannie/Freddie.  The incremental risk vs Treasuries arises because changes in rates and the economy can affect how quickly people are selling, refinancing, or being foreclosed on.  All of those things affect how quickly an investor is getting their money back, thus affecting the value of MBS today).

Depending on the perceived value in investors' eyes, as well as other potential buying needs/goals, MBS may look more or less attractive than Treasuries or other bond-like investments.  In this sense, they compete in the bond market arena like any other fixed-income investment and generally "orbit" around the bond market benchmark--US Treasuries. 

This orbit has been exceptionally wide at times in the past (like the onset of the financial crisis).  But it has also brought MBS value very close to that of Treasuries (like in the time immediately following the announcement of the MBS-specific bond-buying in the Fed's QE3).  During normal times, they remain quite close and MBS simply go through spurts of gaining or losing ground faster  or slower than Treasuries.

The bottom line is that it's the prices that investors are willing to pay for MBS that will determine the nuanced changes in lender rate sheets.  It can absolutely happen where Treasury yields will move one direction on a certain day and mortgage rates move in the other direction.  Now you know why.