An Overview Of How Mortgage Interest Rates Are Determined
Several factors affect how mortgage rates are determined today, but you can only control one aspect: 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 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 to make it more affordable for borrowers to take out loans.
Which Market Factors Affect Mortgage Rates?
Market factors are some of the largest driving forces behind mortgage rates. The Federal Reserve, bond market, Secured Overnight Finance Rates, Constant Maturity Treasury, the health of the economy and inflation all affect mortgage rates.
Many people assume the Federal Reserve sets mortgage rates. They don’t, but the Federal Reserve does affect rates. 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, the prime rate for mortgages usually follows suit shortly afterwards.
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%. These are 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 to keep up with their costs to borrow money from the Fed.
Mortgage rates have a reputation of being tied to the 10-year Treasury note when they’re tied to the bond market.
Mortgage-backed securities, or mortgage bonds, are bundles of mortgages sold in the bond market. Bonds affect mortgage rates depending on their demand. 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.
Secured Overnight Finance Rate
A secured Overnight Finance Rate (SOFR) is an interest rate set based on the cost of overnight borrowing for banks. It’s often used by lenders to determine a mortgage’s base interest rate, depending on the type of home loan. It’s grown in popularity to serve as the replacement for the London Interbank Offer Rate (LIBOR), which is being phased out at the end of 2021.
Constant Maturity Treasury Rates
Constant Maturity Treasury rates, or CMT rates, refer to a yield that’s calculated by taking the average yield of different types of Treasury securities with varying maturity periods and using it to adjust for a number of time periods.
Some lenders will use this rate to determine interest for adjustable-rate mortgages (ARMs). If the CMT goes up, you can expect any loans tied to it to increase their interest rates as well.
Health Of The Economy
Mortgage rates vary based on how the economy is doing today and its 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 and lower demand for oil, mortgage rates fall.
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 slightly fluctuate.
Which Personal Factors Affect Mortgage Rates?
Economic factors aside, many personal factors affect the par rate a mortgage lender will give you. 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.
A high credit score means you’re seen as less of a risk to lenders – 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’re at a higher risk of default.
What credit score do you need? It depends on the loan program. If you want a conventional loan (meaning it won’t be government-backed), you’ll need at least a 620 credit score, but if you choose FHA financing, you’ll need a 580+ credit score.
Taking the steps to check and improve your credit will put you in a better position to get a lower rate from your lender.
Lenders want to know that you’re invested in the home through 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.
Speaking of down payments, lenders also compare your down payment to the loan amount, which is your loan-to-value ratio (LTV). 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.
Lenders also care about whether your home is your primary residence, a second home or an investment property. Interest rates are usually lowest on primary residences because it’s where you live. You’re 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 preapproved 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, which will strongly influence your overall monthly payment. 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.