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The other day, I drove from Orem to Salt Lake City (Utah) and counted 6 billboards advertising specific mortgage interest rates. During the same time (approximately a 45 minute drive), I heard 4 advertisements on the radio quoting even more rates. I lost count of the Pandora mortgage rate advertisements I heard during the rest of my afternoon back at the office.
I would only know this by being in the industry, but each ad that quoted a specific interest rate was exceptionally misleading. Without knowing key information about the borrower and the transaction, quoting rates really is a shot in the dark. With this post, I’ll set forth (simply) how mortgage rates are determined, how to decipher advertising, and where to go for reliable information regarding mortgage interest rates.
How Rates are Determined
There are 2 main drivers with mortgage interest rates (aside from the market). The first is Costs/Fees and the second is Risk Factors.
- Costs/Fees - Mortgage lenders make money either by charging the borrower origination fees or by being paid by the investors that will eventually purchase the loan. Investors (like Wells Fargo, Provident, PennyMac, etc., whoever ends up with your loan after you close) pay more money for higher interest rates, so if a lender wants to make money but not charge you an origination fee, he will give you a higher mortgage rate so that he is compensated by the investor. The same can be done for other fees (like processing fees, administration fees, etc.): either you pay for it and get a lower rate (keep in mind that it is often just added to the loan), or the lender pays it you get a higher rate. Lower Rate = Higher Costs, and vis versa. Below is an example of how costs can affect your interest rate (assuming a $100,000 loan).
You Compensate the Lender The Investor Compensates the Lender
Costs (out of pocket or added to the loan)
$2500 $0
Interest rate
3.625% 4.000%
- Risk Factors – Credit score, how much you’re borrowing (compared to the value of your home), the type of property, etc. are just a few examples of risk factors. The riskier the loan, the more likely that the borrower will default on the loan. That requires a higher interest rate, because investors need to be compensated (by higher interest rates) for lending money in the presence of those risks. Returning to our example, here is how just credit score will affect your interest rate (assuming Lender-paid compensation, it’s a purchase, and the borrower is putting down 5%).
740 Credit Score 640 Credit Score
Interest rate 4.000% 4.625%
How Lenders Quote Misleading Interest Rates
Simply put, lenders often mislead potential clients in their advertising by presenting rates for scenarios that are possible, but not probable (or that are exceptionally rare). They do this by using unlikely assumptions regarding the Costs/Fees and Risk Factors.
- Tactic #1: Quoting rates as if they would do the loan for free – Every lender/loan officer has the option of doing a loan for free, or at least extremely cheaply. Because that is possible, they can advertise rates that reflect that. But lenders don’t work for free (and they shouldn’t), so you will soon find once you start signing documents that the lender is not working for free and, consequently, your rate is much higher than advertised.
- Tactic #2: Quoting rates with no Risk Factors – A billboard knows nothing about you or the financing you’re looking for. It’s possible that you have a 800 credit score and a 50% down payment (though quite unlikely, at least in regards to the down payment), so they can advertise a rate that reflects those unlikely assumptions. However, once they pull your credit, appraise the home, etc., your rate will be significantly higher once all of the Risk Factors are accounted for.
Lenders often combine these two tactics. An average client of mine has a 700 credit score, an 80% LTV, and is refinancing to take out some cash to pay off credit cards (those are the risk factors). Below is a final example of how this rate could be advertised and what it would actually be:
Advertised (working for free, no risk factors) Interest Rate
3.625%
Actual Interest rate
4.500%
About APR
APR (Annual Percentage Rate) is often cited in advertising. APR is meant to allow borrowers to compare interest rates and costs; a note rate that has a significantly higher APR means that you will be paying significant fees/costs to get that rate. So, if Lender A advertises a 4.00% interest rate with an APR of 4.125% while Lender B advertises a 4.00% interest rate with an APR of 4.750%, Lender A has the better offer. The APR is required to be quoted in certain advertising instances as it is meant to force lenders to be more truthful in their advertising, but it doesn’t work, because it doesn’t keep lenders from quoting “work for free” loans and rates that don’t include risk factors.
What to Do
Here’s a little secret about the mortgage world: due to compensation regulations and the fact that all mortgage lenders are selling their loans to most of the same investors, rates don’t vary much from lender to lender. That doesn’t mean that lenders won’t reduce their commissions to be competitive in some instances, but that is the only power they have, and it doesn’t happen very often (i.e. most lenders are earning about the same on their loans/rates).
Some tips:
- If you’ve been given a quote from a lender you trust (who has actually learned about your situation, pulled your credit, etc.) and you get a quote from another that is substantially lower, don’t trust it.
- Take billboard/radio/TV advertised rates with a boulder of salt. To be safe, add a 0.5% - 1% to what their advertising as a more accurate representation of what your rate would be.
