The average 30-year fixed mortgage rate has dipped to 4.57%, from 4.62% a week ago. Although rates have been inching upwards over the last few months, they are still near historic lows. The time series from the St. Louis Fed reminds us that rates were closer to 6% in 2005 and 8% in 2000.
Although frequently reported by the press, the average mortgage rate does not tell the full story. Mortgage lenders use risk-based pricing, which means people with higher credit scores tend to receive lower interest rates. Although economists regularly opine on when the average rate will cross the 5% threshold, recent research from LendingTree (which owns MagnifyMoney, where I work) shows that the average APR for people with scores below 680 crossed 5% a long time ago. For people with scores between 680 and 719, the rate crossed 5% earlier this year. People with the best scores continue to receive offers well below 5%.
Key Drivers Of Mortgage Pricing
Mortgage lenders take two levels of risk. The first risk is the creditworthiness of the borrower. Lenders need to assess the willingness and ability of borrowers to repay, which is typically measured by a credit score (usually a version of FICO) and an affordability ratio (known as the debt burden). The second level of risk is the LTV (loan to value ratio). In the event a default, the lender will attempt to repossess and sell the home. The lower the LTV, the more likely the bank will not lose money in the event of a default.
To calculate the interest rate, lenders think about both the frequency and severity of a potential loss. The borrower's willingness and ability to repay is the frequency, and the LTV is the severity. The lowest expected loss rate would come from someone with an excellent credit score and very low LTV. For example, imagine a borrower with an 800 FICO and 60% LTV. The 800 FICO tells lenders that it is very unlikely that the borrower will default. And a 60% LTV tells a lender that even in the event of a default, the bank probably would not lose any money. Compare that to someone with a 600 FICO score and 97% LTV. From the eyes of the lender, there is a higher chance of the borrower being unable to pay. And if that does happen, a loss is likely because of the high LTV. Fannie Mae has a loan level price adjustment worksheet that gives an indication of how lenders will price for risk.
The average interest rate reported in the press is helpful to give an overall direction of the market. But for potential borrowers, understanding the risk-adjusted rate is much more important.
Tips For Potential Home Buyers
If you are planning a home purchase, consider these three tips:
- Your FICO score matters: Most mortgage lenders use an older version of the FICO score (you can find out which version here). Check your score before you apply. If you are on the margin, focus on reducing your card utilization, paying on time and avoiding credit inquiries. Make sure you dispute any inaccurate information. Just a few points can make a big difference.
- Try to save a down payment of at least 20%. Not only will the overall cost of your mortgage be lower, but you will also reduce the risk of being stuck in your home with negative equity. As 2008 reminded us, house prices can decline.
- Comparison shop for your mortgage. Rates can vary significantly between lenders. Twenty basis points on a mortgage can have a big impact over the life of the loan. Shopping around can help you save significant money.
