If you’re a first-time homebuyer, you might be overwhelmed by the profusion of advice online regarding interest rates. How to get a low interest rate . . . Types of loans with the lowest interest rates . . . When to lock in your interest rate . . . Interest rates vary greatly depending on a variety of factors, including your credit score, the type of loan, and when you choose to apply for a loan. So, you might be wondering, why do interest rates change? And what do you need to do to secure the best interest rate possible?
Why Do Interest Rates Change?
Before we explore why interest rates rise and fall, it helps to have a clear understanding of what interest is. Simply put, interest is the cost of borrowing money. Borrowers agree to pay interest in order to be able to spend immediately. Lenders charge interest to offset the risks that come with lending money. After all, the borrower could default or rising inflation could mean that the money loaned has less purchasing power when it is finally repaid. An interest rate is basically the price tag of a loan expressed as a percentage of the principal. But why do interest rates change, and what factors affect them?
Supply and Demand
The concept of supply and demand is a driving force in the American economy, so it’s no wonder that it influences interest rates. According to the American Monetary Association, lenders only have so many resources to use to fund loans. When there is a high demand for loans, interest rates rise because the supply of funds lowers. When social or economic forces make entities reluctant to borrow, the demand for loans decreases. In response, lenders offer lower interest rates as an enticement.
Rising inflation often correlates with rising interest rates. Pocket Sense suggests several reasons for this. For starters, higher inflation reduces purchasing power, so lenders need to charge higher interest rates to make up the difference. Likewise, reduced purchasing power can make meeting financial obligations increasingly difficult, so borrowers are more likely to default. Higher interest rates help offset this. Finally, as inflation increases the cost of doing business, profit margins shrink. Charging higher interest rates allows lenders to balance out their rising costs.
News organizations are quick to report on moves made by the Federal Reserve because any change in monetary policy can have a major effect on interest rates. How does the Fed influence the economy? While just a hint of action can be enough to send ripples through the economy, the Fed typically influences interest rates by buying or selling previously issued U.S. securities. As Investopedia explains, if the federal government sells securities, money is drained from the coffers of banks, and with fewer funds available for lending, interest rates rise. Alternately, if the government purchases securities, then money is pumped into banks, making more funds available and decreasing interest rates.
Although we’re exploring a single question – why do interest rates change? – and how it affects American homebuyers, global factors should be a consideration as well. As NerdWallet points out, issues don’t have to be domestic in nature to impact interest rates; global factors affect the U.S. economy, so they affect interest rates. Global issues like political unrest, natural disasters, foreign competition, and shifts in the costs of food or fuel can impact economies around the world.
How Do Homebuyers Secure the Best Interest Rate?
With so many factors affecting interest rates, what does a homebuyer seeking a mortgage need to do to secure the best interest rate? Ultimately, lenders who provide home loans want to be repaid, so they tend to offer the best interest rates to borrowers who they believe will repay their loans. How do you persuade a lender that you’re a good risk? When it comes to getting the best interest rate, Forbes suggests that consumers improve their financial standing by considering the following factors:
- Credit Scores: Lenders use your credit score as a tool for evaluating your creditworthiness. Generally speaking, the higher your credit score, the lower your interest rate will be. If your credit score is on the low side, you might want to take a little time to repair your credit and increase your credit score before applying for a mortgage.
- Debt-to-Income Ratios: A debt-to-income ratio compares your monthly debt obligations to your monthly income. Since a borrower who gets in over their head is more likely to default, lenders like to see healthy debt-to-income ratios.
- Financial Stability: Before lending money, banks want to know that you’ll have sufficient income. Borrowers who can demonstrate steady employment and earnings can expect better interest rates than peers who have a spotty employment history.
- Down Payment: A borrower who can make a sizeable down payment will enjoy a better interest rate. Why does the size of the down payment matter? When a borrower has a small down payment, lenders consider the loan to be riskier, so they charge a higher interest rate to protect their financial interests.
- Cash Reserves: Having a cash reserve that is equal to or greater than at least two months of mortgage payments will often result in a lower interest rate because it raises the lender’s confidence in the borrower’s ability to meet their loan obligation.
So why do interest rates change? Many things impact interest rates, including the concept of supply and demand, inflation, monetary policies, and global factors. By proving that you’re in good financial standing and highly likely to repay your loan, you can enjoy a low interest rate when you buy your new home.
When you’re ready to get started, contact PrimeLending if you live in the Kansas City area. Our committed team will help you navigate the home hunting process so that you can purchase the home of your dreams. At our branches located throughout Kansas City, we can help you explore our wide variety of loan products and programs. Plus, PrimeLending utilizes delegated underwriting, local appraisers, and cutting-edge technology to accelerate the underwriting and closing processes. When you’re ready to learn more, please give us a call at 844-701-5626.