Interest Rate Determinants
The most frequently asked questioned by borrowers is "what’s your rate?" They often expect you to quote a rate without their providing you much in the way of pertinent information other than their name. The easy, open ended answer is "I have programs with rates that range from 2.125% to 12%. Let’s see which one applies to you and what you’re trying to accomplish."
What borrowers often fail to realize is the complexity of coming up with a VALID quote because not only do the rates change daily, with occasional intraday rate changes, but that each lender may have 20-50 different loan programs. On top of this, Cypress Realty & Mortgage, my parent company is approved with over 20 different lenders. So, if you do the math, there are literally dozens of different programs. Each program has 10-15 different parameters that influence the pricing.
What most brokers do (if pressed by a borrower for a number on the spot) is quote from the one or two lenders they use most often and depending on what they think the borrower wants to hear they quote the program with the lowest rate or they opt for the standard 30 yr. fixed. Some don’t bother qualifying the borrower by running their credit—they simply quote them the "A Paper" rates and later inform them that they are deficient in some regard. Obviously, this can present problems down the road.
RATE vs. PRICE
There are two elements that determine a rate quote: one is the INTEREST RATE, the other is PRICE. The INTEREST RATE is the prevailing percentage of a sum of money charged for its use. The PRICE is the amount that one has to pay to obtain a particular rate. Example: The interest rate for a loan of $500,000 is 6%, but the price (or hit to the price) to obtain this rate may be 0.5% or $2500. Par pricing is where there is no money paid or rebated to obtain a particular rate. New loan officers frequently use the two interchangeably with disastrous results. They make adjustments to rate instead of to the price and vice versa.
Aside from lenders’ guidelines and Debt To Income (DTI) ratios. ALL OF THE FOLLOWING BOLDED HEADINGS AFFECT THE INTEREST RATE:
Lenders’ base interest rates are determined by the size of the loan. There are three categories: Conforming (under $417,000), Agency Jumbos (417,000 - 546,250), and Non Conforming (everything above 546,250). The smaller loan amounts, typically, have base interest rates that are lower by 0.25% to 0.375%.
With a lower LTV (Loan To Value) classification, there is a reduced risk of default for the lender and consequently, the pricing to be had is better. The range varies with the LTV. The best pricing will usually be at LTVs of 60% or less.
FICO SCORES (MID)
Your mid-FICO score is another prime determinant of price. Notice that I said mid-FICO, not the high score, not the low, but the middle score in a tri-merged credit report. If there is a co-borrower or spouse on the loan, the lender will almost always go with the lower mid-score of the two borrowers on the theory that "a chain is only as strong as its weakest link" and so too, with the likelihood of a default on a loan. There are a few lenders, however, that will go with the higher wage-earner or will go with a blended FICO score (the average of the borrower’s and co-borrower’s mid-FICO scores), but this is not the norm.
Financing for one’s Primary Residence will be more attractively priced than for a 2nd Home or an Investment Property (a.k.a. Non-Owner Occupied). The reason for this is that an owner is far less apt to default on the payments on their principal abode than a 2nd home or an investment property. Fannie Mae and Freddie Mac have correlated the risk on investment property to be higher and as result there is 1.75% hit in price, not in rate, for a property being non-owner occupied. As a consequence, the rate usually is adjusted upward to reflect this pricing hit. A 2nd home would likely necessitate an adjustment of only 0.125% in price.
Differing types of property affect the price of a loan. The reason being is in the event of a default certain kinds of property offer better collateral or are easier
for a lender to market than others. An SFR (single family residence) or a PUD (planned unit development) is better collateral than say a CONDO because the land beneath the dwelling is owned outright as opposed to a condo, whereby only the unit is owned outright and the land owned in partnership with the other condominium owners. Lenders are also reticent in lending on condo projects where fewer than 50 or 60% of the units have been sold.
Depending on what a borrower is trying to accomplish the type of loan will have a direct effect on the rate as different loan types have different rates. For example, if a low payment is desired, the ideal vehicle may be an interest only type of loan; if the borrower is looking to shorten one’s pay-off time, he may opt for a 15-year term; and if he doesn’t have much in the way of a down payment he would be forced to go with an FHA (or VA if eligible). All of these programs have different prices and interest rates associated with them, respectively.
The basic rule of thumb is that the more documentation you’re willing to provide the less risk that is attached to a loan for a lender. These days, all loans are FULL DOC.
A rule of thumb that may be applied here is the shorter the term, the cheaper the rate. The options normally afforded a borrower are: 15, 30 and even 40-year terms. Some lenders also offer 10 year terms based on 15 year pricing (with a .25% adjustment) and 20 year terms based on 30 year pricing (again, with a 0.25% adjustment downward). With 40+ year terms one can expect to see price bumps ranging from 0.25% to 0.625%.
INDEXES (ARMS ONLY)
There are several different indexes. Among the most well known and frequently used are the CMT and the LIBOR. The interest rate spread is often as much as a full point. For example, right now (August, 2012) the 1-yr.CMT is at .19%, the 1-yr. LIBOR stands as 1.0661%, the COFI is at 1.116%, the MTA, at 0.1475% and the 1-month LIBOR, 0.2466%. But this is only part of the story, because the indexes with the lowest interest rates usually have higher off-setting margins which negate the difference in the indexes. Incidentally, difference in the indexes is a factor of their volatility. Some are more stable than others. When rates are rising, those with the greatest volatility will spike the most quickly, but when rates are falling, they will, likewise, be the quickest to drop. For an in-depth discussion of the various indexes, see the October, 2011 newsletter (vol. 8, issue 10 on the website).
LENGTH OF FIXED RATE (ARMS ONLY)
Normally, the shorter the period that the rate remains fixed, the cheaper it is. Thus a 6 month Libor (where the rate is fixed for 6 months and adjusts based on the LIBOR Index) is apt to command a lower rate than say a 3/1 Treasury (where the rate is fixed for 3 years and adjusts annually based on the CMT (Constant Maturity Treasury Index). The fixed rate periods range as follows: 1 month, 6 month, 1 yr., 3 yrs., 5 yrs., 7 yrs., 10 yrs., 15 yrs., and 30 years. Thus, a loan that’s fixed for 30 years would typically command the highest premium. With a normally ordered yield curve one might expect to see an eighth of point spread between the various fixed rate periods. I say "normally", because in the past few years we’ve had several instances when the yield curve has been inverted, during which time, short term (6 mos. – 3yrs) money at fixed rates has cost more than intermediate term money (5-7 yrs.) and numerous instances where long term (10-30 yrs.) less dear, than 3-5 yr. (short-intermediate term) money. Right now, the pricing on 3/1 ARMs is costlier than that of 5/1 ARMs.
The range of lock times is between 15-75 days. Lock periods are usually in 15 day increments; the longer the lock, the higher the price. At present, the spread is about 1/16 of a point per 15 day extension.
If you’re refinancing a property and need cash out (beyond $2,000) you can expect to see a .25% adjustment upward in the price.
Prepayment penalties used to be prevalent. Few loans, these days, have them. They existed in increments of 1, 2, 3, & 5 years.
POINTS, OR NO POINTS?
Do you want the lowest rate or the lowest price? If you want the lowest rate you’ll opt for the wholesale price, but this will necessitate an origination fee. If you desire the lowest price, you may be able to get a rate only a quarter percent higher that will pay the broker a rebate via your lender credit, thus saving you thousands of dollars in origination fee. If you’re holding time is less than 5 years, it will probably benefit you to go with rebate pricing as opposed to wholesale pricing.
Nearly all lenders offer reductions to borrowers if they have their taxes and insurance impounded because it diminishes the chance of a tax lien (which would affect the lender’s collateral) or lapses in insurance coverage (which would affect the lender’s security). The differential is ordinarily 0.25% in price. Impounds are typically mandatory, if the LTV is above 80%.
Interest rates can be bought down either permanently or temporarily. Buy downs are not cheap, however, as a "general rule of thumb," a discount point of 1% will lower your fixed interest rate loan 0.25% and your adjustable interest rate loan .375%. In other words, it would be necessary to pay 1% of the total loan amount in price to lower your rate a ¼ to 3/8 of a percent.
With LTVs (Loan To Value) above 80% one has 3 choices: one loan with Mortgage Insurance included, a fixed rate 2nd or a variable rate loan like a HELOC (Home Equity Line Of Credit). With an LTV in excess of 80% one can expect one’s price on the 1st to increase anywhere from .25% to 1.5% depending on one’s FICO and LTV.
IF SOMEONE QUOTES YOU A RATE WITHOUT ASKING QUESTIONS WITH REGARD TO THESE FACTORS, I WOULD STRONGLY QUESTION THEIR COMPETENCE AND CREDIBILITY.
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