How are mortgage rates determined?

When you get a mortgage, one of the most important factors influencing the cost of your loan, both overall and on a month-to-month basis, is the mortgage rate. The mortgage rate, or interest rate, describes the cost of borrowing money as a percentage of the loan amount each year. The higher the rate, the more you’ll pay.

There are many factors that influence your mortgage rate, some of which you can control and some of which you can’t. Understanding what these factors are and what you can do to influence your loan’s rate is key to getting the best possible loan.

How economic factors affect mortgage rates

Some of the things that influence the interest rate of your mortgage are based on broad economic factors that are largely out of your control. Understanding how these factors impact rates can help you time your mortgage application or decide when to refinance.

In general, these economic factors all play a role in the Federal Reserve’s, the central bank of the United States, decisions regarding benchmark interest rates that influence mortgage rates. When the Fed raises its benchmark rates, mortgage rates tend to rise and vice versa.

The performance of financial markets

The performance of financial markets for things like stocks and bonds can play a role in determining mortgage rates. Often, when markets perform poorly, the Fed will take steps to strengthen the economy, which can involve lowering benchmark rates. That, in turn, makes mortgage rates lower.

Housing-specific market performance can also play a role. For example, a slow housing market can lead to more competition amongst lenders as fewer buyers enter the market, causing rates to fall.

The state of the economy

One of the Federal Reserve’s mandates is to keep prices stable and maintain maximum employment. Central banks make adjustments to benchmark rates such as the Federal Funds rate or LIBOR as part of their efforts toward achieving that goal.

When the economy is in recession, that can mean cutting rates. With a strong economy, the Fed may boost rates to prevent things from getting overheated. That impacts rates. For example, during the 2008 recession, rates fell from more than 6.75% in 2007 to a low in the mid-to- high 4% range in 2009.

On the other hand, a strong economy may also lead to higher housing prices as more buyers enter the market and generate competition amongst lenders, forcing them to compete by offering lower-cost loans.

Inflation

Another mandate of the Federal Reserve is to target an inflation rate of 2% in the long run. The primary tool it uses to reach this goal is adjusting benchmark interest rates, which affect mortgage loan rates.

When inflation is high, raising rates discourages borrowing and spending, helping lower inflation. When inflation is too low, cutting rates can boost spending and borrowing by making loans cheaper.

Lender-specific criteria

Individual lenders may offer different loan rates due to factors like their overhead costs or whether they offer loans backed by Freddie Mac or Fannie Mae. For example, online lenders typically have lower overhead costs, which often lets them charge lower rates than brick-and-mortar banks.

How your financial profile impacts your rates

While you don’t have much control over the state of the economy or the inflation rate, there are some things that you can control that impact the cost of your mortgage. These generally relate to your personal financial history and situation.

Your credit history

Your credit history and credit score play a massive role in your ability to get a mortgage and how much that mortgage will cost. Lenders price their loans based on the perceived risk of an applicant. In general, the better your credit, the lower the odds that you’ll default on your loan.

Lenders charge lower interest rates to lower-risk borrowers, so boosting your score can help you secure a lower rate. Before you apply for a loan, take any steps you can to improve your credit score, such as paying down your existing debt balances and checking your report for errors that can be removed.

Your debt-to-income ratio

Your debt-to-income (DTI) ratio is the percentage of your monthly income that you pay toward your existing debts. For example, if you make $5,000 per month and spend $1,200 on credit card, student loan, and auto loan payments, your DTI ratio would be 1,200 / 5,000 = 24%.

The lower your DTI ratio, the more money you have available each month to pay your bills and the less likely you are to face a financial crunch. Many lenders have maximum DTI ratios, above which they will deny loan applications, but having a low DTI ratio can help you land a lower rate.

Down payment

When you buy a home, you usually need to make a down payment equal to a certain percentage of the home’s value. The minimum will depend on the type of loan you’re using but is often around 3% or 3.5%. ¹ However, there can be major benefits to offering a larger down payment.

For one, a larger down payment means borrowing less money, which makes your loan cheaper. It also reduces the lender’s risk by lowering the amount the lender is giving you and reducing the odds that the home’s value will fall so far that selling it isn’t enough to repay the loan. That can help you secure a lower rate.

Before buying a home, do your best to save for a down payment and make sure to look into down payment assistance programs in your area.

Application features that influence your rates

Some aspects of the loan you’re applying for also influence the rate of your loan. You’ll work these factors out when you apply.

Type of mortgage

One big factor influencing the interest rate of a mortgage is the type of loan you apply for. There are many different loan programs, each with different requirements, pros, and cons.

For example, a conforming loan is one where you meet all of the credit score, DTI ratio, and loan amount requirements set by entities like Freddie Mac and Fannie Mae. This makes it easy for lenders to sell your loan on the secondary market, reducing risk. That means conforming loans often have better rates than other loan types.

On the other hand, jumbo loans are often for larger amounts, increasing lender risk. That means that jumbo loan rates are typically higher than interest rates for other loans.

Property type

The type of home you’re buying and the purpose you have in mind for the home also impact your interest rate. For example, lenders will usually offer better rates to people buying a primary residence than those buying a rental because people buying a primary residence have more to lose should they default on their home. Commercial property rates are often even higher.

For another example, rates for mortgages on condos are often higher than those for loans used to buy single-family homes because lenders have to control for the risk of shared ownership of the building.

Loan terms

When you get a loan, you can usually select its term, meaning the length of time it will take to pay the loan off. For mortgages, typical terms are 15 and 30 years. The shorter the term, the lower your mortgage rate is likely to be.

Shorter terms result in lower rates because there is less time for things to go wrong and for the borrower to default on the loan. That means less risk for the lender. Just keep in mind that shorter terms lead to higher monthly payments because you need to spread the repayment of the same amount of principal over a shorter period.

You may also see adjustable-rate mortgages. These loans have low initial rates, but the rates can change over time, possibly rising significantly. These are generally best for people who plan to sell the home in a few years or who can afford the potentially rising payments down the road.

Mortgage points

Mortgage points are a form of prepaid interest that you can add to the upfront cost of your loan. Typically, one mortgage point costs 1% of your loan amount, and each point reduces your loan’s rate by 0.25%, but check your loan paperwork to get precise details for your loan.

For example, if you get an offer for a $400,000 loan at 6.5%, you could pay for two points, adding $8,000 to your closing costs but reducing your interest rate to 6%.

In general, paying for points is a better idea the longer you plan to keep your mortgage. If you pay for points and sell or refinance too soon, you may wind up spending more on the points than you saved from the lower interest rate.

Estimate your monthly payment using this mortgage calculator from Rocket Mortgage.

FAQ

Mortgage rates can be complicated, but buying a home is a major financial decision, so it’s important to understand what impacts the rate of your loan.

What determines the interest rate on a mortgage?

There are many factors that impact the interest rate of a mortgage. Some, like your credit score, debt-to-income ratio, and down payment amount, are under your control. Others, like inflation and the state of the economy, are out of your control.

Why do mortgage rates change?

Mortgage rates can change for many reasons. For example, if your credit score rises, you might be able to secure a lower interest rate. If inflation goes up, the Federal Reserve may increase its benchmark rates, which can cause mortgage rates to rise.

How do mortgage points help with high interest rates?

Mortgage points are a form of prepaid interest, and each point you pay for can lower the interest rate of your loan. The longer you keep that loan, the more money you may save in interest over the long run.

How does my down payment impact my rate?

The larger your down payment, the less money your lender has to lend to you and the more equity you have in the property. Both of these things reduce the risk the lender is facing by offering a loan, helping lower rates.

Which types of mortgages have the best rates?

Generally, conventional conforming loans have the best interest rates because applicants meet a series of credit and financial requirements and aren’t borrowing immense sums. They are also easy for lenders to sell on the secondary market, allowing them to recoup their money quickly, further reducing lender risk.

The bottom line: Mortgage rates fluctuate, but you are still in control

Mortgage rates change constantly, sometimes for reasons you can’t control, but there are just as many factors influencing loan rates that you can control. Before you start shopping for a home, do your best to pay down your debt, boost your credit score, and save for a down payment so you can secure the best interest rate possible.

If you’re ready to apply for a home loan, you can reach out to Rocket Mortgage and learn more about home loan options to find the one that’s best for you.

¹ The 3% down payment option is only available on certain conventional loan products and is not available in all states. Additional terms and conditions may apply.