Understanding how mortgage rates work

Mortgage interest rates are calculated by banks and other mortgage lenders in accordance with central bank rates and competitive conditions. In the United States, the Federal Reserve is given the responsibility of setting rates in order to maintain economic stability. The situation in Canada is similar, with the Bank of Canada (BoC) setting the prime interest rate in order to meet its monetary policy objectives.

How rates are calculated by central banks

Interest rates are one of the primary tools used by central banks to maintain a level of stability within the country's financial system. Among other objectives, interest rates are set in order to keep inflation at a stable level, with 2 percent the ideal midpoint within a 1 to 3 percent target range. Along with interest rates, other tools used by governments include the management and distribution of currency and the sharing of statistics and information with the public.

Central bank interest rates have a powerful effect on economic growth and stability, with any change to rates having a huge effect on consumer borrowing, consumer spending, and other macroeconomic factors. By changing the discount rate and prime rate over time (see below for more on this), and setting a federal funds rate target, the central bank can affect the building blocks of the economy, alter the transmission mechanism of monetary policy, and affect the cost of money itself.

What is the discount rate?

The discount rate is the interest rate set by central banks and charged to commercial banks and other mortgage lenders. In order to lend money to customers for mortgages and other financial products, banks receive short-term loans from central banks. Whether it's the Fed in the United States or the Bank of Canada, short-term federal lending is needed to ensure ongoing liquidity. In essence, the discount rate is the cost of borrowing money from the central bank.

In the United States, the discount rate is a special administered rate set by the boards of the Federal Reserve Banks and approved by the Board of Governors. The bank's 12 regional branches offer short-term loans, often overnight, to commercial banks that require additional liquidity. Despite different names given to the banks and interest rates, the situation in Canada and most other modern developed nations is similar.

The discount rate can be broken down into three primary components: the primary credit rate, the secondary credit rate, and the seasonal credit rate. While the primary credit rate alone is often referred to as the discount rate, the more expensive secondary rate is also available to some institutions. A seasonal rate is also used by banks servicing the tourism industry, the agriculture industry, and anyone who is likely to experience predictable seasonal fluctuations.

What is the prime rate?

The discount rate should not be confused with the prime rate, the latter of which is an index used to determine individual consumer loan product rates. The prime rate is also set by the central bank, with banks and other institutions then setting their own rates which are added on to this figure.

The prime rate is the underlying index used for a number of credit products, including most credit cards, lines of credit, home loans, car loans, and personal loans. Above all else, the business of lending money involves the assessment and management of risk. Default risk is the primary determining factor used by banks and other mortgage lenders when they initiate interest rate charges.

In many ways, the prime rate acts as a point of reference for all other interest rate charges. While it may not apply directly to mortgages and other loans, it is the measure of the best interest rate available if certain ideal conditions are met. Small business loans are also indexed to the prime rate, which has a huge effect on almost all of the money available to individual borrowers.

The prime rate used by banks in the United States is the one published by the Wall Street Journal. Because it's a federal interest rate, it does not vary from state to state. While the discount rate is an internal figure that is not publicized, the prime rate is known to consumers and can be used as a reference when comparing mortgage products.

While the prime rate is also a short-term rate, it's not as short-term as the discount rate, which is typically an overnight lending rate. Just as the central bank makes the discount rate available to financial institutions with good credit, so too do banks make the prime rate available to customers who are deemed credit-worthy. While both the discount rate and the prime rate have a significant impact on the cost of borrowing money, the prime rate is easier to identify and has close links to commercial interest rate figures.  

What is the federal funds rate?

The discount rate is also confused with the federal funds rate, with both of these rates offered to financial institutions rather than individual customers. Despite this similarity, the federal funds rate is distinctive and often lower than the discount rate. While the discount rate is charged by the federal bank to financial institutions, the federal funds rate is the interest rate used by banks and other institutions when they lend money to each other on a short-term basis.

While mortgage customers are not affected directly by the federal funds rate or discount rate, both have a drastic influence on how interest rates are charged to individual borrowers. In Canada, the federal funds rate is often referred to as the overnight rate, with the target level for that rate also referred to as the Bank's policy interest rate. Just like the federal funds rate, this refers to the interest rate used by major financial institutions when they borrow and lend one-day funds among themselves.

Fixed term vs adjustable term rates

There are many important things to consider when you're getting a home loan, from neighbourhood and lifestyle considerations through long-term growth projections. Despite all of these decisions, making the choice between a fixed term or adjustable home loan is perhaps the most important consideration of all. A fixed-rate mortgage has a consistent rate over time, with an adjustable or variable-rate mortgage going up or down in accordance with the federal rate index.

A fixed interest rate home loan will remain fixed for the entire term of the loan. Whether you have a 10-year mortgage or a 30-year mortgage, the monthly payments will be the same for the entire term. Whether this is a good idea or not depends on the current market interest rate being offered by the lender in question. If the prevailing interest rate is low, it may be a good idea to lock it in. If the current interest rate is high you may want the flexibility of a variable rate mortgage.

Pros and cons of a fixed term mortgage

Fixed-rate mortgage loans are reliable and easy to manage. The consistent rate offered in a fixed contract makes it easier for people to budget on a day-to-day and year-to-year basis, with this type of mortgage loan offering confidence and stability to people who are looking at their options and planning their financial future. Fixed rate mortgages are often the choice of new buyers and people with long-term 15 or 30-year contracts.

A fixed rate mortgage is not ideal for everyone, with stability often coming at a price. Along with being unable to benefit from interest rate drops, fixed-rate loans often have limits on extra repayments, no redraw facilities, and high break fees. While some of these things differ between institutions and mortgage products, in general, a fixed rate mortgage is less flexible than a variable-rate mortgage.

Pros and cons of a variable term mortgage

Variable rate home loans are flexible and free to move with current market conditions. While they are not as stable as fixed rate loans, they can be more affordable and often come with additional features. For example, adjustable home loans normally allow you to make extra repayments at no extra cost, provide unlimited redraw facilities, and make it easier for you to switch loan products.

Adjustable-rate mortgages (ARM) are not beneficial in all situations, with any increase to the prime rate or discount rate likely to increase your repayment amounts. The variable nature of these loans also makes it much harder for people to budget, with lower costs often accompanied by increased mortgage stress. Even when interest rates go down, you will never be sure if or when they're going to rise again.

Average mortgage interest rates over the years in the United States

30_Years_Fixed_Rate_Mortgages.png

Historical interest rates have changed a lot in the United States over the last few decades, with fixed-rate contracts reaching above 18 percent in the early 1980s and as low as 3.31 percent at the end of 2012. Since the housing crisis and credit crunch of 2007 and 2008, interest rates have stayed well below 6 percent. While property prices are high in many large cities, mortgage holders continue to benefit from historically low-interest rates. Today's rates are between 4 and 5 percent. 

The 1970s were a time of fairly low-interest rates, with 30-year fixed-rate mortgages sitting around 7 percent for most of the decade. This all changed in the early 80s when high-rate loans started to emerge as part of the Federal Reserve's plan to tackle unsustainable inflation. The highest rate was recorded in October 1981 when 30-year mortgage contracts hit 18.63 percent. It's been a reasonably steady decline since then, with the lowest figure of 3.31 percent recorded in November 2012.

While 15-year fixed contracts have followed the same trends as 30-year mortgages, the decline in variable home loan rates has diverged at times. Five-year ARMs have historically had lower baseline interest rates than standard 30-year mortgages, with the biggest divergence seen since 2009. Since 2005, initial interest rates for variable term loans have averaged 0.71 points lower than comparable fixed-rate mortgages.

Average mortgage interest rates over the years in Canada

The prime lending rate in Canada has also changed dramatically over the years, from as high as 22.75 percent in 1981 to as low as 2.25 percent in April 2009. While these changes mirrored trends in the United States over the same time period, as you can see, they were slightly more extreme. The Bank Lending Rate in Canada averaged 7.34 percent from 1960 until 2018. Today's mortgage rates, from May 2018 are sitting around 3.45 percent.

Can you predict interest rates?

Despite the existence of long-term trends, interest rates are notoriously difficult to predict. Since the global financial crisis in 2007, interest rates have been at historically low levels, with the Federal Reserve seemingly committed to raising short-term rates over the next couple of years. With a tightening labour market and possible wage rises on the horizon, a complicated sequence of events may be needed to keep inflation from rising above its target range.

According to Kiplinger's latest forecast, interest rates are likely to increase by a quarter of a percentage point twice more in 2018, which will put the federal funds rate at 2.25 percent heading into 2019. If the economic situation stays the same until then, another three or four rate increases of a similar magnitude are expected.

Kiplinger is expecting to see an increase on the 10-year Treasury note by the end of 2018, from 2.8 percent to 3.3 percent. The bank prime rate is expected to go up from 4.75 percent to 5.25 percent, with the 30-year fixed rate to reach 4.7 percent, and the 15-year fixed rate to hit 4.3 percent.

In Canada, the BoC left its target for the overnight rate unchanged at 1.25 percent in April, a move widely expected by market analysts. According to FocusEconomics Consensus Forecast, the policy rate should end 2018 at 1.73 percent and rise to 2.31 percent by the end of 2019. It's important to note, however, that any forward forecasts regarding interest rates are limited, with the central bank always setting rates in relation to liquidity, demand over time, and market risk.

Interest-only loans

An interest-only mortgage is a special kind of home loan where the borrower pays only the interest on the property for the term of the contract. Once this term is over, the borrower may begin paying off the principal of the loan, refinancing the home, or make a lump sum mortgage payment. If they choose to start paying the principal, the repayment amounts are likely to increase significantly.

Interest only loans terms are normally available between five and seven years, with all monthly payments made during that period being tax-deductible. Even though an interest-only loan can be risky and expensive in the long run, there are a number of benefits to this approach.

For example, interest only loans may allow someone to purchase a home faster and borrow a larger amount. This can be useful for people who want to sell the property within a short time period, or people who want to invest their funds elsewhere in order to get a higher rate of return.

Interest only loans can be risky, however, especially if the mortgage is variable rate. Rising interest rates can make it difficult for people to manage their funds during the contract term, with higher principle payments also causing mortgage payment shock when the contract ends.

While this type of loan can make sense if your income is set to increase in the future, lower income than expected or slow property appreciation can lead to unsustainable repayments, difficulties refinancing, and financial penalties.

Jumbo loans

A jumbo loan or jumbo mortgage is a type of home loan that exceeds the conforming loans limits set by the Federal Housing Finance Agency (FHFA). The large size of these mortgages brings up a number of challenges because they are not eligible to be purchased, guaranteed, or securitized by Fannie Mae or Freddie Mac.

Mortgage brokers set their own underwriting guidelines for jumbo loans, which means it's more important than ever for people to do their research and compare products. Depending on your jurisdiction, the starting size for a jumbo loan ranges anywhere from $417,000 to $625,500.

Because these loans don't meet conforming standards, mortgage brokers may require a larger deposit amount, demand a better credit score, or come with a higher interest rate. Generally speaking, lenders will require a credit score of 680 or higher and a debt-to-income ratio of 40 percent to 43 percent. Additional paperwork may also be needed, with private mortgage insurance (PMI) also required by some lenders.

Escrow

Escrow is the process whereby a third party acts as a middle-man between the buyer and seller in a financial transaction. A neutral third party can be especially valuable when mediating real estate deals, holding money and property for both parties until all conditions are met and everyone is satisfied. While escrow can be used for any type of financial transaction, it is often mandatory when it comes to property sales.

Escrow agents are nominated by the buyer and seller when they have agreed on a purchase price and satisfied the demands of a contract. The agent will typically collect a fee based on a percentage of the sale price when he or she will hold both the property and the deposit amount in escrow for a period of time. Once the final exchange has been completed and both parties are satisfied, the property and deposit will be transferred between parties.

An escrow account has a slightly different meaning, with these specialized accounts often set up by lenders in order to facilitate monthly mortgage payments. After you make your repayments every cycle, the lender will place a portion of the funds into this account in order to satisfy things like taxes and insurance premiums. Because these funds are held securely in escrow, it reduces the risk that you'll fall short of your financial obligations as a homeowner.

Mortgage prepayment

When it comes to mortgages, prepayment describes the process of paying off the loan early. Whether it's an ongoing sum transferred on a regular basis or a large once-off payment, prepayment helps you to reduce interest charges and own your home sooner. While some lenders and home loan products allow prepayments, others restrict them or apply prepayment fees or closing costs.

While new federal rules have been designed to prohibit prepayment penalties on some mortgage products, it's always important to do your homework before signing a contract. New Consumer Financial Protection Bureau (CFPB) rules prohibit prepayment penalties for most residential loans, except for fixed-rate loans that are also qualified mortgages and do not have an annual percentage rate higher than the Average Prime Offer Rate.

Even though the changes introduced by the CFPB are quite restrictive, there are still many situations where penalties can be applied. Prepayment penalties are also subject to several restrictions, however, and can only be applied during the first three years after the loan is consummated. For the first two years after consummation, the penalty can't be greater than 2 percent of the outstanding loan balance. Lenders must also offer loan options without prepayment penalties and provide accurate information about penalties.  

Mortgage interest tax deductions

Mortgage repayments are a significant part of many people's monthly budgets, so it's important to make as many savings as you can. Interest paid on a mortgage can be tax deductible, as long as it comes within certain limits and is itemized correctly on your tax form. In the United States, the interest paid on first or second mortgages can be deducted up to $1,000,000 in value, or $500,000 if you're married and both people are filing separate claims. Anything above this amount is not tax deductible.

There are lots of home loan tax calculators that are capable of working out interest deductions based on the mortgage amount. Mortgage interest deduction is not limited to property purchases and can also be used to deduct the interest paid on any loan used to build or make improvements. Interest from home equity loans also qualifies as home mortgages interest and can be tax deductible if certain conditions are met.

Along with the limit in mortgage value, the date of the mortgage and how the proceeds of the mortgage are used is also important. In addition, these deductions are only available if the homeowner’s mortgage is a secured debt, which means you need to have signed a legal mortgage contract, a deed of trust, or a land contract that secures ownership of the property in question.

Mortgage Rates FAQs

Q. What is the amortization calculation?
A. Amortization is the process of reducing the value of an asset or loan by a periodic amount. Each time that a monthly payment is made it includes part of the principal plus the interest incurred over the period. The longer the amortization period, the lower your monthly payments will be, but the more you'll end up paying over the loan term.  

Q. How are interest charges calculated?
A. Your monthly interest is calculated using an amortization formula, with the interest charged based on the principal amount and current or fixed interest rate offered by the lender.

Q. When is interest paid off?
A. At the beginning of a loan period, most of the money is used to pay off the interest. This will slowly change throughout the loan term, with most of the repayments going towards the principal at the end of the loan.

Q. Should you pay off your mortgage sooner?
A. While it's normally a good idea to make extra repayments and reduce your mortgage principal, financial experts often recommend paying off higher-interest products first, including short-term loans and credit cards.

Q. Are adjustable rate mortgages (ARMs) cheaper?
A. Evidence has shown that adjustable-rate mortgages are typically more affordable over a long time period, although they can also be riskier. If an adjustable rate mortgage is held for long enough, the interest rate will surpass the going rate for fixed-rate loans.

Q. What should you look out for as a first-time homebuyer?
A. First-time home buyers should do a lot of research and potentially get professional help. Learning and understanding property taxes, loan-to-value ratio, and the rate lock can be really helpful to first-time buyers, and guide them to make the best possible decision. 

Q. What is cash-out refinance? 
A. A cash-out refinance happens when you already have a mortgage and you decide to refinance your mortgage for more than you owe and keep the difference in cash.

Q. What is an origination fee? 
A. An origination fee is a fee that the mortgage lender charges upfront for processing the application.