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How Is Mortgage Interest Calculated?


Overall, the combined average mortgage loan interest rate for U.S. Home loans continues to hover at record low rates. For September 2010, the Federal Housing Finance Agency (FHFA) reported that its “National Average Contract Mortgage Rate for the Purchase of Previously Occupied Homes by Combined Lenders” was at 4.55%, a 30-year low.

Interest Rate Benchmarks

Within that averaged rate are a variety of different mortgage interest rates, depending on which base industry standard rate the loan is anchored to and the credit standing of the specific homeowners or business owners in question. The two main interest rate benchmarks used by the U.S. Home loan industry are the prime rates as set by the Federal Reserve and the London Interbank Offered Rate, or LIBOR. In the former case, the prime U.S. Lending rate is generally arrived at by adding three percentage points to the bank-to-bank lending rate as set by the Federal Reserve. So, for example, a prime rate in October 2010 of 3.75% is the byproduct of a base-level Federal Reserve benchmark of 0.75% plus three percentage points.

Back-End Rate Influences

Individual banks add another layer of interest on top of that base prime rate level, and in many cases offer borrowers the option of buying points at the time of the loan origination, which can help reduce the loan’s overall interest rate. Along with this so-called “back-end” set of mortgage rate influence factors, there is the equally important “front-end” determinant of a borrower(s) FICO score.

Front-End Rate Influences

In the United States, three credit bureaus – Experian, TransUnion and Experian – use a complicated and regularly updated formula to determine the financial profile and loan suitability of every individual in the country. This so-called FICO score is the biggest variable affecting the different range of mortgage interest rates for individuals borrowing money from a bank. To put it in the simplest hypothetical terms, couple number one buying a property may be offered a 30-year fixed mortgage rate of 5.0% while couple number two will be able to do no better than 5.75%, all because the latter pair have a less impressive combined financial history.

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