Teeter-totter: Mortgage rates and closing costsDecember 01st, 2010
How is it that in doing your homework before submitting an application for a new home loan or refinance mortgage that there are such a wide range of rates being quoted? Perhaps because you are only getting the interest rate and not the full rate quote. When using mortgage calculators to determine a monthly payment or savings from a refinance, keep in mind the cost of the mortgage for which you are applying.
Mortgage rates and closing costs
On a closing cost calculator you are asked to input loan fees, discount and origination points. How do you know what to put in for these fees? On a monthly payment calculator you are asked to input the mortgage amount and mortgage rate. For mortgage rate you can get a general idea by listening to advertisements on radio or television or in your local paper. Typically however the quote includes the basic rate and the higher "APR," but not the costs of the loan, i.e. the origination fee or discount points.
Both the costs and the mortgage rate affect your transaction, but how do they relate? At any given moment in the market, mortgage rates and costs are inversely related, meaning that as one goes up the other goes down, just like the teeter-totter on the schoolyard. Imagine you and your spouse on a teeter-totter. You are holding onto your monthly mortgage payment which is determined by the interest rate. Your spouse is holding the cost of the loan. As you go up your spouse goes down; the higher the mortgage rate the lower the costs. When your spouse goes up you go down; the higher the closing costs for the mortgage the lower the rate on the mortgage.
Every day the contents of the teeter-totter change slightly. Today it may be that 4.00 percent costs two points and 4.50 percent is available at no points. With changes in the market those rates tomorrow could be 4.125 percent at two points and 4.625 percent at no points. Despite the shift upward in the rate the relationship remains the same, higher rate means lower cost, lower rate means higher cost.
Where is the teeter-totter?
The teeter-totter is a metaphor for the secondary markets which are established for the sale of mortgage backed securities (MBS) which consist of mortgages like yours. When your mortgage funds, chances are it will be a Fannie Mae, Freddie Mac or Ginnie Mae mortgage insured by the government, either FHA or VA. Your mortgage rates and costs are established by the daily behavior of MBS investors.
Your mortgage is bundled with others and sold as part of an MBS offering. Acting like bonds issued by the U.S. Treasury or other entity like a municipal government or corporation, MBS offerings have yields to investors. Yield is the investor term for interest rate; instead of paying interest, however, the investor receives the yield on the investment.
Mortgage rates depend on market activity
Depending on what investors feel will be happening in the economy, what other investment opportunities are offering in yield for similar risk and other factors, investors bid higher or lower for the MBS offering. Just like at an auction the more active bidders the higher the price, the fewer bidders the lower the price.
As with mortgage rates and costs, MBS prices and yields are also inversely related. The more bidders for mortgage backed securities the higher the price and the lower the yield. When there is high demand for MBS, it is beneficial for consumers searching for mortgages as lower yields mean lower mortgage rates.
Every day the bidders for MBS alter the rates being offered for all mortgages. And as the bidding changes daily so too do the mortgage rates being offered. The teeter-totter moves depending on how many bidders and how active they are. One day the no-point loan may be at 4.50 percent and the next day it could be 4.625 or 4.375 percent.
Not always proportional
Further complicating the mortgage rate and price relationship is that they do not always move in direct proportion. A general rule of thumb is that on a 30-year fixed-rate mortgage a difference of one-eighth of a percent (0.125 percent) in rate is equivalent to a difference of one-half of a point in fees (0.5 percent of the loan amount).
This is a general rule of thumb, but often the difference can be more or less depending on the market. For example, raising the rate one-eighth of a percent from 4.00 percent to 4.125 percent may lower the cost of a loan 0.5 points. However, raising the rate another one-eighth of a point (from 4.125 percent to 4.25 percent) may only lower your cost another 0.25 points.
Play on the teeter-totter
On any given day when you are considering locking in your mortgage rate and costs on your application ask your mortgage professional for the costs and rates above and below the rate for which you applied--you may be able to save money in the short or long term by having your teeter-totter go up or down. Play around with the mortgage calculators to get familiar with this relationship between costs and mortgage rates and your monthly mortgage payment.