Understanding the Impact of Interest Rates on Mortgage Loans

Interest rates play an integral role in determining the cost of borrowing. Interest is the amount of money a borrower will pay to borrow money and can be one of biggest reservations that prospective homebuyers have. Yet, as much as the economy affects interest rates, interest rates affect mortgage loans on an equal or greater scale. Prospective homebuyers and mortgage professionals should have some knowledge of the interplay between interest rates and mortgage rates, and how they affect the homeownership journey.  

A Dance Between Interest Rates & Mortgages 

Mortgage loans are financial instruments that allow people to buy property, most often homes, without having to pay the full lump sum up front. Banks, credit unions, and mortgage companies act as lenders, and prospective buyers apply to request the amount of the loan they need. Homeownership has often been touted as one of the keys to financial growth because of the equity built over time.  

Of course, mortgage lending is a business, and home loans are not free. Borrowers must pay the cost of borrowing, also known as interest rates. These rates bring an equilibrium to all of the financial activity that happens in the world. Interest rates are managed by the central banks, and they shape financial policy around these changes.  

Interest rates play a part in several of the common consumer activities that we participate in. Consumer spending can be spurred or hindered by interest rates, with lower rates encouraging spending and borrowing. In the mortgage industry, interest rates have a direct impact on mortgage rates and ultimately, demand for homes. When rates are higher, the demand for homes will often decrease.  

Interest Rates Explained: A Simple Guide 

Interest rates are influenced by several factors that play off of one another, either in the short-term or long-term. Let’s look at some of the key factors that shape interest rates. 

1. Central Bank Policy. Central banks, such as the Federal Reserve in the United States, set long- and short-term interest rates based on economic activity. 
2. Inflation. Usually, central banks have an inflation target in mind and if inflation rises above their ideal rate, they will raise interest rates to slow the economy down. In periods where inflation is significantly below the target, the reverse is true. 
3. Employment Rates. In a down economy, the central banks may lower interest rates to encourage job creation. 
4. Government Bonds. Government bonds are generally considered low-risk investments. The higher the demand for them, the lower the yield, so banks will lower interest rates to compensate for this. 
5. Politics. Political factors can have an effect on interest rates due to the risks associated with changing political landscapes. 

Keep in mind that these factors serve as important decision-making tools for not only policymakers, but consumers as well. While it’s hard to predict the exact direction of the economy at any given time, certain markers can give faint hints as to what may happen.  

How Interest Rates Impact the Cost of a Mortgage 

Interest rates determine the cost of a mortgage. Not only does the interest rate affect the cost of borrowing, but it affects other aspects of your mortgage, as well. 

1. Monthly Payments. The higher the interest rate, the higher the payments will be. The reverse is also true. Also, when the interest rate is higher, more of the payment ends up going toward the interest instead of the principal. 
2. Affordability. The more interest a mortgage has tacked onto it, the more the home costs. This is why in times of higher interest rates, the demand for homes may decrease.  
3. Loan Amounts. The interest rate affects the total amount that a borrower can qualify for. A lower interest rate will cover more of the loan’s principal, making payoff easier.  
4. Inflation. In a strong economy, the central banks will raise interest rates to combat inflation. However, that increase also affects mortgage rates, making the cost of borrowing increase. 

If the total financial impact of the mortgage loan is a major consideration for a homebuyer, they should monitor interest rate trends to make the most beneficial decision. For those who already own homes but may want to refinance, it is equally important to stay abreast of interest rate patterns.  

The Different Types of Mortgage Interest Rates 

There are several types of mortgages, and within each, the interest rates behave differently. The main distinction is how the rates are structured and how constant they are.  

1. Fixed-Rate Mortgages. The interest rate in a fixed-rate mortgage stays constant throughout the life of the loan. The monthly payment will stay the same. The advantage of this type of mortgage is predictability. Borrowers should also consider that the interest rate on FRMs could be higher than other types of mortgages that change according to the market. 
2. Adjustable-Rate Mortgages. Adjustable-rate mortgages have an interest rate that can change according to the market. They generally begin with a fixed rate for an initial period and then start to adjust. The advantage of an ARM is that the initial fixed-rate may be lower than that of an FRM. However, borrowers will also experience changing monthly payments as the market changes. 
3. Interest-Only Mortgages. This mortgage type allows borrowers to initially pay only the interest for a specified period of time, after which they’ll begin to pay both the principal and interest. The advantage of this type of mortgage is that there are lower initial monthly payments, but after the interest-only period ends, borrowers could see a significant jump in their payments.  

Choosing the right mortgage type will depend on several personal factors. For example, if your client wants to buy a property that has a higher cost, you may want to advise them to explore an adjustable-rate mortgage. If their source of income is not likely to change over time, a fixed-rate mortgage may offer the long-term stability they need.  

The Effect of Changing Interest Rates on Existing Mortgages 

The effect that interest rates have on existing mortgages varies by the type of mortgage. Let’s look at some common mortgage types and how they may be affected by interest rates. 

1. Adjustable-Rate Mortgages. Borrowers who have an ARM will experience changes in their loan’s interest rate, and thus, their monthly mortgage payment. The scale and frequency of these changes depend on the loan agreement. ARMs will usually have a cap or limit to prevent homeowners from severe rate fluctuations; however, their mortgage payment is still subject to an upswing leading to an increase in the total cost of borrowing. 
2. Fixed-Rate Mortgages. Fixed-rate borrowers are safe from the effects of changes in interest rates. In fact, if rates drop after they take out their mortgage, they may be able to refinance at the lower rate.  
3. Interest-Only Mortgages. During the interest-only period, the interest rate remains fixed. After the interest-only period is over, the loan will be transferred to a different structure and the rate could then be affected by the market rate. 

Refinancing 

Refinancing is when a new mortgage replaces an existing mortgage. Homebuyers will use refinancing to secure a more attractive interest rate or other terms. Here are some considerations when making the decision to refinance. 

1. Interest Rates Could Decrease. Getting the new loan with a lower interest rate allows borrowers to have a lower monthly payment and overall cost of borrowing. 
2. Quicker Payoff. Loans at a lower interest rate could help a borrower pay off their mortgage sooner. Over the life of the loan, this could result in substantial savings. 
3. Interest Rates Could Increase.  There may not be incentive to refinance if doing so could increase higher mortgage payments.  
4. Closing Costs. Similar to when the initial loan closes, refinancing comes with its own closing costs. The time that it takes borrowers to recoup closing costs may not be worth it.
5. Equity. Lower interest rates can help build equity when the payments are applied to the principal. A borrower could consider this when deciding to refinance.  

Navigating Interest Rates as a Mortgage Loan Originator 

Mortgage loan originators are responsible for guiding prospective homebuyers through the mortgage process, so having a firm understanding of how interest rates work is essential for several reasons: 

1. Financial Planning. MLOs who understand how interest rates work can help their clients formulate a plan to assess how much house they can comfortably afford. They can also educate refinancing clients about what to expect. 
2. Customized Service. Clients have different goals and MLOs should be able to tailor loan products to those individual needs. This is easier to do when the loan officer is knowledgeable about how market forces, such as interest rates, may play into different loan products. 
3. Proactivity. A loan officer who knows the factors and conditions that affect interest rates can offer more proactive advice to clients.  
4. Compliance. Mortgage industry ethics indicate that the MLO provide clients with accurate information. In addition to the final loan terms, loan officers should be able to answer questions that arise during the general course of client interactions. 

Financial principles can be complex. However, MLOs – and prospective MLOs – should make sure they get sound education so that they can provide high caliber service to their clients.