Mortgage Market Efficiency and the Reason to Question Price Outliers

By Douglas Katz – 08/25/2023

Have you ever wondered why the mortgager interest rates seem to be in a specific range? I see so much activity from investors to find super low rates as well as questionable lenders who promote unattainable loan terms and it makes me crazy.  The individuals looking for the deals are on a fool’s folly and the lenders promoting the rates are unethical at best.  It’s all because of something called “market efficiency.” Let’s dig into this concept and understand why super low mortgage rates might not be as common as you think.

Understanding Market Efficiency and Mortgage Rates

Think of the real estate market as a giant marketplace where lenders (those who give out mortgages) and borrowers (those who want to buy houses) interact. Market efficiency means that the forces of supply and demand work together to set fair prices. In our case, it’s about finding the right interest rate for mortgages. Lenders compete with each other, which helps keep mortgage rates reasonable and within a certain range.

The Range of Mortgage Rates

Picture a group of mortgage rates lined up from the lowest to the highest. Most of these rates will be around the middle, with only a few rates being extremely low or high. Why does this happen? Lenders want to make money, so they set rates that cover their costs and bring in some profit. This means rates can’t be too low, or else lenders wouldn’t make enough money. On the other hand, rates can’t be too high, or borrowers would go elsewhere for better deals.

Risk-Based Pricing and Its Impact

Now, let’s talk about risk. Lenders want to be sure they’ll get their money back, so they look at how risky a borrower might be. Risky borrowers might have lower credit scores or less money to put down on a house. This goes beyond the intuitive FICO component of risk.  Everything from the down payment to the property type drive the risk to the lender and this risk is consistent from lender to lender. Lenders will offer higher rates to these borrowers to make up for the extra risk. This way, they’re being fair to both safer borrowers and themselves.  While lenders may integrate compensating factors to their analysis and pricing, no lender can ignore risk and stay in business.

Chasing Super Low Rates: Logical or Illogical?

It’s tempting to look for the lowest possible mortgage rate.  As I referenced previously, I see borrowers, especially in the investment portion of my lending business, fruitlessly looking for unattainable rates for their credit profile as well as lenders who prey on their unsophistication to bilk them.  I get it, who doesn’t want to save money? But here’s the catch: really low rates outside of the current established range should mean red flags and warning lights. Imagine a person with a low-paying job trying to buy a huge house or in my investment lending business an inexperienced investor with no down payment and a FICO of 600.  Some lenders might offer them a super low rate to attract them, but this is a sign that something might not be right. In such cases, it’s like a sweet deal that’s too good to be true.

The Efficiency Fallacy: Questioning Super Low Rates

If you’re shopping for a mortgage and you come across a rate that’s incredibly low, it’s time to put on your detective hat. Market efficiency keeps rates within a certain range for a reason. Lenders know what they’re doing – they want to make money, but not by taking unnecessary risks. So, if a rate seems way too low compared to the others, it’s a good idea to ask questions and do some research. There might be hidden risks that you need to be aware of.  I always tell prospective borrowers to make sure they understand why their pricing is what it is and what contributed to the terms.  This helps them understand the concept beyond their current transaction and helps them in later deals.

Shop Smart

Remember, the real estate market is like a big balancing act. Market efficiency ensures that mortgage rates are fair and reasonable for everyone involved. So, when you’re searching for a mortgage, don’t just focus on the lowest rate. Consider the bigger picture and the risks that might be lurking behind that super low rate. By being a smart and informed borrower, you can make the best decision for your financial future.

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