People often ask us what the interest rate on FHA loans is. The answer is pretty simple: It is normally very close to the rates on a conventional loan.
As we have discussed before, an FHA loan is essentially the same as a conventional loan. Banks still loan you the money, the difference is that with FHA loans Uncle Sam is co-signing with you. So while banks might reject your conventional loan application because your credit score is below 680 or because you have less than 90% equity in your home, when you bring Uncle Sam along banks become willing to approve your loan because they know that if you default they can turn to Uncle Sam to get their money back.
So then how are mortgage interest rates determined? The answer is pretty simple. The best mortgage rates tend to be 2-3% greater than the rate on the 10-Year Treasury Note. So while you often hear news about the Fed dropping the “Key Rate” or news about the stock market, it is the 10-Year Treasury Note that is the best indicator on where mortgage interest rates will be — including FHA rates.
This week the the rate on that index has shot upward and unfortunately mortgage interest rates have followed. But with any luck the rates will drop again soon. October 2008 has been a volatile month in the financial markets to say the least.
Here is an excerpt from an interesting article at cnnmoney.com from a few years back explaining this concept of how mortgage rates are determined in more detail:
Basically, when you take out a mortgage, a bank, mortgage company or other mortgage originator is making you a loan at given interest rate. Sometimes the firm that makes the loan holds onto it.
But more often than not, the lender or mortgage originator sells that loan to an institution that packages it with other mortgages into what’s known as a mortgage-backed security and then sells that security to investors. That investor, whether it’s a mutual fund or a large institutional investor, earns a return by collecting the principal and interest payments that you and all the other mortgage borrowers make.
In order to get investors to buy those mortgage-backed securities, they must pay rates of interest that are competitive with alternative interest-paying investments such as Treasury bonds.
You might figure that, since a 30-year mortgage has the same term as a 30-year Treasury bond, mortgage rates might track the rates on long-term Treasury securities. In fact, 30-year mortgages remain outstanding on average about 10 to 12 years, so rates on 30-year mortgages tend to track the yields on 10-year Treasury notes.
Of course, since you and other mortgage borrowers aren’t as good a credit risk as Uncle Sam, rates on mortgages are somewhat higher than those on 10-year Treasuries. In general, 30-year mortgage rates are about two percentage points higher, but that spread can vary depending on the supply and demand for Treasuries and mortgage-backed securities as well as a number of other factors.