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How Are Mortgage Rates Determined? A Comprehensive Look

Sam Hawrylack6-minute read

May 16, 2021

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Interest rates are a primary concern when buying a home. A low interest rate means an affordable mortgage payment, and a high rate makes it difficult to afford or possibly even get approved.

But how are mortgage rates determined, and what can you do to make sure you have a low rate?

Check out this guide on mortgage rates and how they are determined.

An Overview Of How Mortgage Rates Are Determined

Several factors affect how mortgage rates are determined today, but you can only control one aspect – the personal factors. Lenders look at your qualifying factors to determine your risk level. The better your qualifying factors, the better the interest rate they’ll offer.

But it all starts with the current rates – the market rates, so you may wonder how the market affects interest rates.

Mortgage rates are affected by the overall economy. When the economic outlook is good, rates tend to increase, and rates fall when they’re not so great. It seems somewhat backward, but here’s the reasoning.

When the economy is doing well, borrowers can afford more. Without increased rates, the demand for mortgages could exceed the bandwidth of most lenders. Slightly rising rates keep everyone on the same level.

Conversely, when the economy declines and unemployment rates increase, interest rates fall in an effort to make it more affordable for borrowers to take out loans.

Frequency of Interest Rate Changes

Every day, banks receive rate sheets. This doesn’t mean rates change daily, but they can. In fact, they can change multiple times a day. If you have your eye on an interest rate, it’s best to talk to your lender about locking the rate in quickly before it changes.

15-Year Vs. 30-Year Mortgage Rates

If you can afford a 15-year mortgage with its higher payment, you’ll get a lower interest rate. That’s because it costs banks more money to lend money for 30 years versus 15. If they can receive their money back in half the time (15 years), they’ll reward borrowers for it with lower interest rates.

Great news! Rates are still low in 2021.

Missed your chance for historically low mortgage rates in 2020? Act now!

Which Market Factors Affect Mortgage Rates?

Market factors are some of the largest driving forces behind mortgage rates. The Federal Reserve, bond market, the health of the economy, and inflation all affect mortgage rates.

Federal Reserve

Many people assume the Federal Reserve sets mortgage rates. They don’t, but they do affect it. The Fed controls short-term interest rates by increasing them or decreasing them based on the state of the economy. While mortgage rates aren’t directly tied to the Fed rates, when the Fed rate changes, mortgage rates usually follow suit shortly afterward.

The Federal Reserve controls short-term interest rates to control the money supply. When the economy is struggling, as has been the case during COVID-19, the Fed lowers rates, which is why you’ve likely heard rates are close to 0%. That’s not the rates given to consumers, but the rates at which banks can borrow money to lend to consumers.

When the Fed decides they need to tighten up the money supply, they raise the Fed rate. While this doesn’t directly increase mortgage rates, eventually, banks and lenders must follow suit in order to keep up with their costs to borrow money from the Fed.

Bond Market

Mortgage rates have a reputation of being tied to the 10-year Treasury note when they are actually tied to the bond market.

Mortgage-backed securities or mortgage bonds are bundles of mortgages sold in the bond market. When the demand for mortgage bonds is high (usually when the stock market performs poorly), mortgage rates increase, and when the demand is low, mortgage rates decrease.

Health Of The Economy

Mortgage rates vary based on how the economy is doing today and its future outlook. When the economy is doing well, meaning unemployment rates are low, and spending is high, mortgage rates increase. When the economy isn't doing as well (like during the COVID-19 pandemic), including high unemployment rates, mortgage rates fall.

Inflation

Mortgage rates and inflation go hand-in-hand. When inflation increases, interest rates increase too so they can keep up with the value of the dollar. If inflation decreases, mortgage rates drop. During periods of low inflation, mortgage rates tend to stay the same or fluctuate only slightly.

Which Personal Factors Affect Mortgage Rates?

Economic factors aside, many personal factors affect mortgage rates too. Lenders have interest rates they can charge for the “best borrowers,” and they adjust rates for the “riskier borrowers.” Fortunately, you can control your personal factors, which means you can indirectly affect your mortgage rate.

Follow these guidelines to get the best mortgage rate possible.

Credit Score

A high credit score means you’re a good risk – you pay your bills on time and don’t overextend your credit. When lenders pull your credit, they see you as a responsible borrower with a low risk of default.

This leads lenders to give you a better interest rate - one that’s closer to the advertised rates because they don’t have to adjust for a low credit score. When you have a low credit score, lenders often change the interest rate significantly because you are at a higher risk of default.

What credit score do you need? It depends on the loan program. If you want a conventional loan (not government-backed), you’ll need at least a 620 credit score, but if you choose FHA financing, you’ll need a 580+ credit score.

Down Payment

Lenders also care about how much skin in the game you have. In other words, they want to know that you’re invested in the home through a down payment and that you aren’t borrowing 100% of the funds. The more money you have invested in the home, the less likely you are to default.

If you put down less than 20% on a home, your mortgage rate will increase, and you’ll need to pay mortgage insurance. There are different types of insurance depending on your loan program, some are cancellable, and some are not.

Besides mortgage insurance, if you put down less than 20% on a home, you’ll also pay a higher interest rate. You’re at a higher risk of default with a lower down payment, and lenders make up for the risk by charging a higher interest rate.

Loan-To-Value Ratio

Speaking of down payments, lenders also compare your down payment to the loan amount, which is your loan-to-value ratio. The less money you put down on the home, the higher your LTV becomes, which is a higher risk for the lender.

When you put little money of your own into the home, you have less incentive to keep paying the mortgage when times get tough. If you have your own money invested, though, you’re more likely to do what’s necessary to make good on the debt.

Lenders charge higher interest rates when the risk of default increases, which is the case with low down payments.

For example, if you make a 3% down payment on a $200,000 loan, you put down just $6,000. But if you make a 20% down payment on a $200,000 loan, you put down $40,000. There’s a big difference between losing $6,000 and $40,000. Lenders usually give the borrower with the larger down payment a lower interest rate.

Occupancy

Lenders also care about whether your home is your primary residence, a second home, or investment property. Interest rates are usually lowest on primary residences because it’s where you live. You are more likely to make your payments on time because you don’t want to lose your home.

If you have a second home or investment property and you have financial issues, you’re more likely to default on the mortgage, putting the lender at risk. Most lenders charge higher mortgage rates to make up for this risk.

How Can I Estimate My Mortgage Rate?

Using an online mortgage calculator, you can estimate your mortgage rate. All you need is a little information, including:

  • Estimated home price
  • Down payment amount
  • Loan term
  • Interest rate
  • ZIP code
  • Property tax and home insurance amount

You can also view today’s interest rates to see where you might fall. If you aren’t sure what type of loan you’d qualify for, consider getting pre-approved to determine where you fall. But if you know your credit score and your approximate loan-to-value ratio, you can estimate your interest rate using today’s rates.

The Bottom Line

Market and personal factors affect your mortgage rate. While you can’t do anything about market conditions, you can control your personal factors. Improving your credit score and saving for a larger down payment are two of the best ways to improve your chances of securing the best mortgage rates.

While you probably wonder how mortgage interest rates are determined, look closely at your personal factors and make them as good as possible to ensure you get the best interest rates available when applying for a mortgage.

If you’re wondering how much mortgage you can afford, check out our mortgage calculator to estimate your mortgage payment at today’s rates.

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Sam Hawrylack

The Rocket Mortgage Learning Center is dedicated to bringing you articles on home buying, loan types, mortgage basics and refinancing. We also offer calculators to determine home affordability, home equity, monthly mortgage payments and the benefit of refinancing. No matter where you are in the home buying and financing process, Rocket Mortgage has the articles and resources you can rely on.