Mortgage Interest Rates
There are two main types of mortgage rates: Adjustable Mortgage Rates (AMR), Capped Rate Mortgages and Fixed-Rate Mortgage.
Adjustable Rate mortgage
Adjustable rate mortgage is the mortgage which interest rates rise and fall with changes in prevailing interest rates. It can also be said to be type of mortgage where interest rate rises and fall with changes in market conditions. When the level of interest rates in open market rises and falls, the interest rates the mortgagor is entitled to receive rises and falls. Therefore, it is possible to reflect as closely as possible what saving institution receives from borrowers and what must be paid to attract funds. ARMs therefore, transfer part of the interest rate risk from the lender to the borrower, and thus are widely used where fixed rate funding is difficult to obtain or prohibitively expensive. The initial interests rates under the ARM are lower the fixed-rate mortgage of equal maturity. Therefore the ARM may be preferable to some buyers since it may make the difference on whether they qualify for a desired home loan or not. On the contrary, ARM may be disadvantageous to the borrower because when the interest rates rises the borrower will pay more.
FIXED-RATE MORTGAGE (FRM)
Fixed-rate mortgage (FRM) is a mortgage in which the interest rate is constant and does not change during the term of the mortgage. The interest rate is fixed at the time of origination. It requires regular payments during the life of the loan, of sufficient size and number to pay all interest due on the loan, and reduce the amount owed zero by the end of the loan’s maturity date.
Lenders of fixed interest loans are exposed to interest rate risk. This is because these mortgages are financed from short term deposits. This is because they generally rely on short term deposits to avail long term mortgages loans. Incase interest rates increase overtime, the financial institutions will incur an increased cost of obtaining funds, consequently, reducing their profits margin. On the other hand, borrowers will not benefit from reducing interest rates; however, they will not be affected by increasing rates.
Capped Rate Mortgages
The borrowers may protect themselves from interest rates increases by taking a capped rate mortgage. This type of mortgage rates fixes the upper limit of the rates while allowing the rates to move downwards (Redhead, 2008 pp 104). The loan provider buys an interest option from a dealer who undertakes to compensate if the interest rates increases. The payments for the option to the dealer reflect the risk which is passed to the borrower.
Determinants of Mortgage Interest Rates
Mortgage Rates and inflation-The Fisher Hypothesis
This theory asserts that there is one-for-one relationship between inflation and interest rates. Actual interest rate changes as inflation changes. This can be explained by the fact that lenders being rational agents will require compensation to their purchasing power occasioned by general increase in prices.
Where the nominal interest rate, r is is the real interest rate and β is the extent to which nominal interest rate change as expected inflation change. In case the real interest rates are constant over time, β=1. Real interest rate is the disparity between the nominal interest rate and expected inflation .
When lenders advance a loan they form some expectations about the probable rate of inflation. If they expect an inflation rate of 8% per annum, they will incorporate 8% to the annual interest rates. Therefore, an increase in inflation expectation will cause long term interest rates including mortgage rates to increase.
Central Bank Rate
It is the role of the central bank to control inflation. One of the instruments it uses to achieve this is the bank rate. When the inflation rises the central bank response by raising the nominal rate and as a consequence the real interest rates rises. Consequently, exports, consumption and investment reduce. The Taylor rule can be used to set the Central bank rate subject to some conditions and can be explained by the following equation:
Where,
y= deviation of GDP from the trend
p= inflation over previous four quarters with a target of 2%
The GDP is growing on its trend at about 2% per annum so that y=0
The ax post interest rate will also equal 2
Although the Federal Reserve does not set long term interest rates such as the mortgage rates, they influence inflation through short term interest rates. The long term interest rates for instance mortgage rates incorporate the future inflation expectations. Therefore, there is a relationship between the short term interest rates set by Federal Reserve and long term inflation expectation. In 2011 the interest rates including mortgage rates were declining in the United States. There was no consensus on the reason behind the decline, the Federal Reserve rate played a key part. The South African interest rates were linked to short term rates and they fluctuated between 13 to 24 per cent which impeded growth in housing sector. However after the introduction of an inflation targeting regime, interest rates have reduced substantially lowered leading to a vibrant property market.
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