It is a life dream for every family to finally access the real estate market and purchase a home. Usually the only way to do that is to combine the family savings with finance from your bank. The same bank you have had a relationship with for many years is now holding your future dreams in its hands. Many people, approach their banker and after a rigorous process of evaluating a loan request, a very important phone call is expected, the one that the relationship officer calls to give you the bank’s decision; Loan Approved (but with what interest rate??) or Loan Declined.
The million dollar question is what leads to that final conclusion?
There are several factors that influence mortgage lending decisions. All of them have to do with risk management. People seem to forget that banks don’t give money but lend money. The ability to repay the loan, as well as the securities provided determine the risk involved to a mortgage application.
The client’s history with the banking system is vital. Someone who has been issuing bouncing checks over the years, who’s bank accounts are always in debit, shows a financial character without self-financial discipline. Such person cannot be expected to honor long term, frequent and consistent mortgage repayments on the long term. That is the main reason for any banking institution to refuse any type of credit to a client.
But even if you don’t belong to this category, a bank has to consider a lot of factors before the approval of any mortgage. It is its main aim to minimize the risk involved with the specific transaction and this is the reason all banks examine every application individually. This is done ascertain the interest rate that they will offer for the specific client, the specific moment, for that specific time with that specific security (collateral)
So when you get a loan, you aren’t the only one taking a risk. The lender is taking a risk on you. Interest rates are the cost of borrowing money, the risk involved, and a kind of insurance for the lender.
In general, the higher the risk, the higher the cost of borrowing money, the less chances for a loan to be approved. If you get slapped with a high interest rate, you shouldn’t necessarily take it personally. The lending institution isn’t just taking a risk on you, it is also taking a risk on the economy as a whole. The lender has to consider such risk despite your stellar credit rating.
So, in simplistic terms, interest rates are determined based on how much of a risk the lender is taking on you, the economy and how “covered” is the loan from the securities you provide.
Mortgage rates, however, are more complex than this. (A mortgage is simply a loan on a house, and a mortgage rate is the interest rate on such a loan.) When you follow the trail, you’ll eventually find an intricate and interconnected web of factors that go into what determines mortgage rates.
Economic Factors that Help Determine Mortgage Rates
Ultimately, several factors, including the rate of inflation, stability of the Real Estate Market, how secure is the collateral ,risk, applicant’s credit ranking affect mortgage rates. That’s because all these factors plus many more affect how much investors are willing to pay to invest in the mortgage-backed securities (MBSs).
Let’s start with inflation, which is the phenomenon where the prices of common goods and services rise across the board. Consistent and moderate inflation is actually a sign of a healthy economy and should
ideally result in a proportional rise in wages for workers as well. For lenders, inflation poses an inherent problem, it means that the money people borrow now will be worth less when they come to pay it back. If economists predict a rise in inflation, investors will insist on higher mortgage rates to make up for this loss.
Having many choices of where to invest their money, competition among other investments also determines mortgage rates for investors. Like with bonds and other financial instruments, investors often compare MBSs against government bonds. You might assume a 30-year fixed mortgage would compare to a 30-year bond. But in reality, borrowers in 30-year fixed mortgages are likely to refinance or move after only 10 years. So investors compare such mortgage investments to 10-year treasuries.
When a Central Bank adjusts certain interest rates, this indirectly effects mortgage rates as well. The Central bank rate is the interest rate banks use when making overnight loans to other banks (to meet end-of-day requirements). To raise this and make borrowing more expensive, effectively lowers the supply of available money, which can help stop a rise in inflation. The reverse is also true: lowering the Central Bank interest rate increases the supply of available money and encourages inflation. As you can probably guess, such adjustments have such wide ripple effects that they affect mortgage rates as well.
Economic and Real Estate Market stability are both very important factors that determine mortgage interest rates as well as the exposure of banks to this type of finance. In most of the cases, when we apply for a mortgage the bank will ask about the property that we are willing to buy as collateral. After evaluating the property, the bank then makes an offer on the amount of money we are requesting as well as the interest rate. If the real estate market is not risky and the value estimated has more probabilities to grow than to shrink, then the interest rates are smaller. The collateral we are using on the mortgage is covering most of the risk. If the market is closer to a “bubble” or the prices are soaring for no reason, which means that within a short period of time the market could go down or even collapse, then the interest rates increase. Actually this is a good and quick way to forecast a market before you invest in any real estate asset. If the banks consider the market to have high risk, then I believe we should think twice before we make any commitment.
Most retail investors, especially homeowners, focus on changing mortgage rates because they have a direct influence on real estate prices. However, interest rates also affect the availability of capital and the demand for investment. Such capital flows influence the supply and demand for property; as a result, they affect property prices. In addition, interest rates also affect returns on substitute investments and prices change to stay in line with the inherent risk in real estate investments. Such changes in required rates of return for real estate also vary during destabilization periods in the credit markets. As investors foresee increased variability in future rates or increase in risk, risk premiums widen, putting increased downward pressure on property prices.
As a conclusion, bank policies are procedures and regulations put in place to govern lending activities within the bank. They are broad guidelines and answer questions such as who the bank can lend to; where the bank can finance; how much the bank can finance; which properties the bank can finance; what kind of securities are acceptable to the bank; how much the bank has a set a limit for loans to the housing sector; and how lending activities will be conducted. Therefore, unless an exception can be granted, any application that is in contravention of the bank policy will be declined.
So, if your financial character is perfect, but still your mortgage was declined (or approved with a ridiculous interest rate), now you know that it is not your mistake. The real reason is that there is an unsustainable real estate market and an economy which is not as bright as people like to think. The banks will not be willing to take the risk of financing your property purchase as the risk involved in the market is very high. They always know better when they should be exposed and when they should simply keep distance from a very fragile market.
Financial institutions are not willing to take the risk of a market and if they do, they want to charge you with astronomical interest rates. Maybe, you should think twice about that dream of buying a house today and wait till when the market will cool down. When real estate values will become reasonable and sustainable, then you can buy. Buying a house is a lifetime investment. Everyone should be very careful and read the signs. Do not follow the crowd, follow the leaders, they know better.
By Kosta Kioleoglou REValuer,
Chief Strategist (CSO) for the East African Region
Director of Engineering – Property Appraisal & Valuations
Civil Engineer Msc – DBM
Taylor Scott International.