How Are Mortgage Rates Determined?

Buying a home is a big step in anyone’s life, and your mortgage is likely the biggest financial commitment you’ll ever make. The interest alone will cost you thousands of dollars, so it is well worth understanding the factors determining the mortgage rate. A small percentage cut in the mortgage rate could save thousands of dollars over the mortgage term. 

Find out all you need to know about how lenders determine mortgage rates and discover how to get the best rates.  

How Are Mortgage Rates Determined?

Two main factors influence the mortgage rate. One is your personal financial position; the other is the economy in general. Your mortgage rate reflects the risk to the lender. The higher the risk of non-payment, the more the lender will expect in return for the money borrowed. Your financial circumstances and past debt payment performance are important risk factors. The availability of money in the economy also influences the interest rate.   

Economic Factors That Affect Mortgage Rates

Economic factors have a significant effect on the mortgage rate. Here’s how:

The Federal Reserve

As part of its monetary policy, the Federal Reserve influences the interest rates through the Federal Funds Rate. This is the interest rate banks charge each other for overnight loans. 

Economic Conditions

The Fed may respond to a weakening economy by reducing the funds' rate. As a result, it becomes cheaper for banks to borrow from each other. When interest rates are lower, the banks may be more willing to lend money to businesses and individuals, driving down mortgage rates. 

Inflation rises in a growing economy. The Fed will raise the Federal Funds Rate in response to high inflation. The raised rate slows economic activity and discourages borrowing. The result is higher mortgage rates. 

The Bond Market

The Fed influences interest rates by buying and selling government bonds. When the Fed buys bonds on the open market, more money enters the market. This pushes up bond prices. The interest rate follows downward, resulting in lower mortgage rates. The opposite happens when the Fed sells bonds on the open market. 

The Loan Market

Competition in the loan market can influence mortgage rates. If lenders have a lot of cash because of low interest rates on other loan types, they may offer borrowers more competitive mortgage rates.

Inflation

Inflation and mortgage rates are closely related. When inflation rises, so do mortgage rates. Because inflation reduces the dollar’s purchasing power, lenders raise interest rates to protect their profits and ensure that they receive a return that can keep pace with inflation. 

The Federal Reserve is responsible for keeping inflation under control. To do this they may raise the Federal Fund Rate. This slows economic activity, pushing mortgage rates up. 

The Constant Maturity Treasury Rate

The Constant Maturity (CMT) rate reflects the risk-free rate of return. It is the average yield of U.S. treasury securities. It is also the benchmark rate lenders use to set interest rates. Some adjustable-rate mortgages (ARMs) are connected directly to CMT indexes, and the initial and adjustment rates are based on the CMT index. 

While fixed-term rates are less impacted by CMT rates compared to ARMs, CMT rates can still influence overall market trends.

The Secured Overnight Finance Rate

The Secured Overnight Finance Rate (SOFR) is the overnight cost of borrowing funds secured by U.S. Treasury Securities. 

Personal Factors That Affect Mortgage Rates

Mortgage rates also reflect the risk of failing to pay the mortgage on time. 

Credit Score

Your credit score is one of the most important mortgage rate inputs because it reflects how likely you are to repay the loan. The higher your credit score, the more likely you will receive loan approval and a lower interest rate. A high credit score reflects a history of on-time debt payments. Even a small credit score difference can substantially impact the interest you pay. Strive to improve your credit score before applying for a mortgage. It could save you thousands over the mortgage term. 

Debt-to-Income Ratio

Your Debt-to-Income ratio DTI shows how much your current income is committed to paying off your existing financial obligations. A lower DTI is preferred as it shows you owe less as a percentage of your earnings. 

Most lenders will cap the DTI at a level they believe borrowers can repay. This amount is usually around 36%, though some may allow a higher amount with compensating factors like high savings. Even if your DTI is below the limit, a lower DTI may earn you a lower mortgage rate.   

Loan-to-Value Ratio

The Loan-to-Value ratio (LTV) represents the borrowed amount as a ratio of the appraised property value. A lower LTV often translates into a lower mortgage rate because it represents lower risk. The greater the part you own in the property, the smaller the lender’s stake. If you must sell the property with a low stake, the proceeds may not cover the loan amount and you’ll still owe the lender money. 

Mortgage Types

The USA has four main mortgage types, each with differing mortgage rate structures.

• Conventional mortgages: Require a good credit rating and a down payment
• Jumbo loans: For more expensive properties. Higher risk means a higher mortgage rate
• Government-backed loans: Include the following:
• Federal Housing Administration loans: Less stringent credit rating requirements. Lower interest.
• Veterans Affairs loans: No down payment is required for eligible veterans. Lower interest rates 
• U.S. Department of Agriculture loans: No credit score or down payment is required for qualifying rural homes 
• Fixed-rate mortgage: The interest rate and monthly payments are set for the full mortgage term. 
• Adjustable-rate mortgage: Interest rates change with economic changes

Fixed vs. Adjustable Rate

A fixed interest rate remains unchanged throughout the mortgage term. Borrowers often prefer a fixed rate because there is more certainty, making it easier to budget. The interest rate on a fixed-rate mortgage is generally higher than the adjustable-rate equivalent. 

For the borrower, an ARM is, riskier as the interest rate can move substantially over the term, affecting the monthly payments.  

Down Payment

If you own 20% or more of the property, you will receive a much lower mortgage rate than if you have a down payment that brings you closer to the LTV limit, which is usually 90%. Your lender may insist on private mortgage insurance if you don’t have a 20% down payment.  

Repayment Term

The mortgage rate over a longer repayment term is generally higher. A shorter term means that the lender’s money is returned faster. As a result, the lender faces less uncertainty and risk from economic factors. 

Property Type and Location 

Use the table below to see the effect of location on the mortgage rate. We have assumed a $200,000 house price with a $40,000 down payment, leaving you with a fixed conventional mortgage of $160,000, paid over 30 years. Assuming you have a credit score of 740 or more, this is what you can expect to pay.

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Occupancy

Planned occupancy affects the level of risk and hence the mortgage rate. Generally, lenders regard a primary residence as the least risky. Borrowers are less likely to default on a property in which they live. Investment property is riskier and will attract higher rates. 

Points and Credits

Points and credits are prepaid mortgage fees. They affect both closing costs and mortgage rates. Each discount point lowers the interest rate by an amount. The reduction depends on the lender, your credit rating and current market conditions. 

Here’s how buying discount points would affect the rate on a $200,000, 30-year fixed-rate mortgage with an initial interest rate of 7.5%. Let’s assume one discount point costs 1% of the loan amount and reduces the interest by 0.25%.  

Prepare to Get the Best Possible Mortgage Rate

Mortgage rates differ from person to person because every lender has different personal risk factors. Knowing how lenders rate your risk can help you to prepare for your first mortgage application. You could save thousands over the mortgage term by improving your credit score, paying off some of your debts and saving for a down payment. 

While you may not control economic conditions, focusing on your personal risk factors can help you secure the best mortgage rate.

Frequently Asked Questions