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Interest Rates

1. What is an APR?
2. How do rate locks work?
3. Why do interest rates change?
4. Effect of economic data on rates
5. When do you lock?

What is an APR?

The APR, often referred to as the Effective Rate, is a rate which shows the true cost of borrowing. This rate is different from the nominal (named or note) interest rate stated in your loan documents. The Truth In Lending Simplification and Reform Act requires mortgage companies to disclose the APR when advertising a rate.

To begin to understand the Annual Percentage Rate, it helps to understand the standard, fixed rate mortgage loan. A standard loan consists of:

1. Loan amount
2. Number of payments
3. Monthly payment amount
4. Nominal interest rate

Given any three of the above four items, the fourth can be determined with the aid of a financial calculator, computer program or algebraic formula. In other words, given any three factors, there is only one correct fourth factor. Here is an example of a fixed rate loan:

1. Loan amount: $100,000
2. Number of payments: 360 (12 payments per year for 30 years)
3. Monthly payment: $804.62
4. Interest rate: $9%

Let's consider a simplified, real estate loan transaction, using the above loan as our starting point. You borrow $100,000 and pay a 1.5 percent loan fee to the bank. For this example, that is the only fee you pay. At the completion of the transaction, how much money do you have? $100,000? No. You have $100,000 less the $1,500 loan fee, or $98,500.

Taking into account the cost of your transaction, let's take a second look at your new loan.

You received: $98,500

Number of payments: 360

Monthly payment: $804.62

Interest rate: ?

Remember, there can be only one correct interest rate given the other three factors. In this example, the interest rate is the APR--9.17 percent. Since the loan amount was effectively reduced (you didn't get $100,000), and the number of payments and monthly payment stayed the same, the interest rate had to increase.

Fundamentally, that's all there is to the APR in a real estate loan transaction. This simplified example recognized only one fee related to obtaining a loan. You'll incur many other costs when obtaining a loan, some effecting the APR, some not, but the principle is the same.

Theoretically, the APR is a number you can use to accurately compare loans among different lenders. Since the APR takes into account costs of obtaining the loan, you should be able to use APRs to find the best loan. Unfortunately, when calculating the APR, not all lenders include all fees, and some lenders may include fewer fees than another lender. What's a borrower to do?

Ask for a signed and dated Good Faith Estimate of Closing Costs (GFE). A properly prepared GFE will itemize all the costs associated with your loan. Only then can you accurately compare lenders' programs.

What fees are included in the APR?

The following fees are usually included in the APR:

• Points - both discount points and origination points
• Pre-paid interest. The interest paid from the date the loan closes to the end of the month. Most mortgage companies assume 15 days of interest in their calculations. However, companies may use any number between 1 and 30!
• Loan-processing fee
• Underwriting fee
• Document-preparation fee
• Private mortgage-insurance
• Appraisal fee
• Credit-report fee

The following fees are sometimes included in the APR:

• Loan-application fee
• Credit life insurance (insurance that pays off the mortgage in the event of a borrowers death)

The following fees are usually not included in the APR:

• Title or abstract fee
• Escrow fee
• Attorney fee
• Notary fee
• Document preparation (charged by the closing agent)
• Home-inspection fees
• Recording fee
• Transfer taxes

Points to remember

An APR is a starting point from which to begin to compare loans. You must get a signed and dated Good Faith Estimate of Closing Costs with which to accurately compare lenders' programs.

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How Do Rate Locks Work?

In most cases when you shop for a loan, the rate and terms you are quoted represent those available that day. The rate quoted probably won't be available next month or next week. Therefore, you should only rely on the rate and terms a lender is willing to lock-in.

A lock-in, or rate commitment, is a lender's promise to close your loan at a certain interest rate and number of points. Depending upon the lender, you may be able to lock in the interest rate and points upon submitting your application, during application processing, upon loan approval, or later. A rate lock protects you against rate increases while your application is being processed. However, a locked-in rate could cost you money in the event rates drop and you want a lower rate.

You will need to lock the rate on your mortgage some time prior to closing. There are five components to a rate lock:

1. Loan program
2. Loan amount
3. Interest rate
4. Points
5. Length of the lock

You must identify each of the above mentioned items in a rate lock. A rate lock might look something like this:  30 year fixed, $150,000 loan amount, 7.5 percent, one point, 30 day lock period. The document describing the lock will contain the date the lock was made and usually the lock expiration date. The lender must disburse funds prior to the expiration of the lock period, otherwise, the rate lock is invalid.

A loan with a below-market interest rate is less attractive to a potential purchaser of the loan. The longer the lock period, the greater the risk that interest rates will increase before the loan closes. To offset this increased risk, the lender charges increasingly higher points and/or interest for longer lock periods.

If rates increase during the lock period and your lock expires, most lenders will let you re-lock at the new, higher rate or points.  If rates decrease during the lock period and your lock expires, lenders usually will charge a penalty to take advantage of the new, lower rates.  For a fee, some lenders allow a "float-down" option which allows you to take advantage of decreasing interest rates. Once a lock expires, be prepared to renegotiate the rate and points.

What do you do if the rates drop after you lock?

Unless you have the option to float-down, most lenders will not budge unless rates drop substantially (3/8 percent or more). Lenders incur fees when they lock loans. If lenders were to allow borrowers to cancel a lock every time rates improved, they'd spend too much time re-locking rates, and the increased costs would have to be passed to borrowers.

Lock and Shop programs.

Most lenders will let you lock an interest rate only in connection with a specific property. Some lenders offer lock-and-shop programs which let you lock a rate before you find your home.  Both programs can be valuable when rates are rising.

New construction rate locks.

Most lenders offer long-term locks for new construction. Since these locks tend to be relatively long, they can be expensive. An up-front deposit is sometimes required also. Most long-term new construction locks offer a float-down.

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Why do Interest Rates Change?

There are several types of interest rates. These include:

• Prime rate: The interest rate banks charge their best (prime) customers.
• Treasury bill rates: Treasury bills are short-term debt instruments used by the U.S. Government to finance their debt. Commonly called T-bills, they mature in less than one year.
• Treasury Notes: Intermediate-term debt instruments used by the U.S. Government to finance their debt. They mature in one to ten years.
• Treasury Bonds: Long debt instruments used by the U.S. Government to finance its debt. Treasury bonds mature in more than ten years.
• Federal Funds Rate: Banks with excess reserves at a Federal Reserve district bank charge this rate to other member banks for overnight loans.
• Federal Discount Rate: The interest rate the Federal Reserve charges its member banks for short-term borrowing to meet liquidity needs.
• Libor: London Interbank Offered Rates. Average London Eurodollar rates.
• 6-month CD rate: The average rate that you get when you invest in a 6-month CD.
• 11th District Cost of Funds: A weighted average of the actual interest expenses incurred for a given month by the savings institutions headquartered in the 11th District of the Federal Home Loan Bank System.
• Fannie Mae Backed Security rates: Fannie Mae pools large quantities of mortgages, creates securities with them, and sells them as Fannie Mae backed securities. The rates on these securities influence mortgage rates very strongly.
• Ginnie Mae-Backed Security rates: Ginnie Mae pools large quantities of mortgages, securitizes them and sells them as Ginnie Mae-backed securities. The rates on these securities influence mortgage rates on FHA and VA loans.

Interest rate movements are influenced by the fundamental forces of supply and demand. Given a fixed level of lendable funds, if the demand for credit (loans) increases, interest rates also increase. I.e., when more people (borrowers) bid for a limited resource (money) the cost of that resource increases. Conversely, if the demand for credit decreases, so will interest rates as lenders lower the cost to entice borrowing. When the economy expands there is a higher demand for credit and interest rates increase.  When the economy contracts, the demand for credit lessens and interest rates decrease.

A fundamental concept:

• Bad news (i.e. a slowing economy) is good news for interest rates (i.e. lower rates).
• Good news (i.e. a growing economy) is bad news for interest rates (i.e. higher rates).

A major factor driving interest rates is inflation. Higher inflation is associated with a growing economy. When the economy grows too rapidly, the Federal Reserve increases interest rates to slow the economy and reduce inflation. Inflation is the increase in the general level of prices for goods and services. When the economy is strong there is more demand for goods and services, so the producers of those goods and services can increase prices. A strong economy therefore results in higher real-estate prices, higher rents on apartments and higher mortgage rates.

Mortgage rates tend to move in the same direction as interest rates. However, actual mortgage rates are also based on supply and demand for mortgages. The supply/demand equation for mortgage rates may be different from the supply/demand equation for interest rates. This might sometimes result in mortgage rates moving differently from other rates. For example, one lender may be forced to close additional mortgages to meet a commitment they have made. This results in them offering lower rates even though interest rates may have moved up!

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Effect of Economic Data on Rates

The number of + symbols indicate the potential effect on interest rates.

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When do you lock?

You know when rates have hit bottom AFTER they start rising. Deciding when to lock your rate is a bit like gambling--you want luck on your side!

You must lock your rate prior to closing your loan. To help determine when to lock, consider the rate trend. When rates are falling, wait until the last possible moment to lock your rate. When rates are rising, lock your rate as soon as possible. In either case, you're basing your decision on something unknown--the future. Rate trends change quickly and interest rates usually change daily. Here are just a few of the factors affecting interest rates:

1. New economic data.
2. Supply and demand of debt. Example: The U.S. government sells 30-year bonds; the supply of bonds increases; an increased supply of bonds at a given level of demand causes the price of bonds to fall; falling bond prices create increasing bond interest rates. Conversely, when the demand for bonds increases at a given level of supply; the increased demand bids up the price of bonds, resulting in lower rates.
3. Inflation. Actual or expected higher inflation causes rates to climb. When inflation is on the rise, the Federal Reserve Board raises rates to curb inflation.
4. Political news and world events. A war in the Middle East could cause higher oil prices and inflation.
5. Market sentiment.

Bond rates and prices vary inversely--i.e., when bond prices rise, interest rates fall and vice versa. The 30-year bond is one of the most relevant rates to track, but the yield of mortgage-backed securities is more important. The supply and demand for mortgage securities may be different from 30 year bonds. There are times when bond prices move higher and mortgage security prices move lower.

If you want to follow interest rates, consider the following:

1. Find out all the economic news being released over the next two weeks.
2. Make a list of news that is most important to interest rates--inflation, industrial production, etc.
3. Follow bond- or mortgage-backed prices on a daily basis. These rates influence mortgage rates.
4. Follow mortgage interest rates on a daily basis. Bookmark web sites or obtain rates via e-mail.
5. In general, Fridays and three-day weekends are bad for interest rates. This is because traders hate uncertainty. In many cases, traders close out positions before a weekend, which often means that they have to sell bonds which causes rates to go up.

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