How Are Mortgage Rates Determined?

Buying a home is a major financial undertaking. After all, the median home listing price in the U.S. was nearly $230,000 in 2019, and the prices have only gone up since then. If you need to obtain a mortgage loan to complete the purchase, it can get even more expensive.

When you add in a mortgage loan, you’ll also be adding in interest on the money you borrow for your home purchase. The amount of interest you’ll pay hinges on current mortgage rates, so it’s well worth knowing where they’re at — and how they work.

The good news is that right now, mortgage rates are at an all-time low. So while buying a home isn’t cheap, you can save a ton on interest if you make a move while rates are at bottom rung levels. Before you take the leap, though, you’ll need to know how your mortgage rate is determined and how that affects your loan.

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In this article

    What factors determine mortgage rates? 

    Let’s start by answering the question: how does mortgage interest work? You’ll either have a fixed mortgage interest rate or a variable rate, depending on the type of mortgage you choose.

    Fixed-rate mortgages are more popular because they provide an interest rate that never changes over the life of the loan. The rate you start with is the rate you end your loan with. That gives you predictable monthly payments that won’t change.

    Variable rates, on the other hand, are interest rates that can change with the market over the life of your loan. These rates start out as fixed for a period of time and then change to rates that fluctuate depending on the market and other factors.

    No matter which type you opt for, your mortgage rate will determine how much interest you’ll pay for the money you borrow over the life of your loan.

    [ Read: How to Calculate Your Mortgage ] 

    But how do interest rates work, and how are they determined, when it comes to a mortgage loan? A handful of factors play a role in determining average rates in the market, which is the starting point for the rate you’ll be offered. You also bring unique factors to the table — like your credit score and your other existing debts — and these factors will further shape the rate you get.

    So, how are mortgage rates determined? Here are the broad strokes that lenders consider:

    • Market rates: It’s a common misconception that the Federal Reserve sets mortgage interest rates, but that’s not true. Mortgage-backed securities (MSBs) are the driving force here. Most lenders only hold a mortgage for a short period of time before bundling it with other mortgages and selling it to investors as a MSB.

    When there’s a lot of demand for MSBs, mortgage rates generally go down. Case in point: today’s low mortgage rates. Because the economy has been unsteady in the last year, people are turning to safe investments, including MSBs. With more demand for these bundles of mortgages come lower rates.

    • The type of mortgage you want: In general, you’ll pay more in interest for a 30-year mortgage than for a 15-year mortgage loan because you’re paying the interest for a longer period of time. The rates are often lower for shorter-term loans, too. If you choose a mortgage with a variable rate, like a 5/1 adjustable rate mortgage, the rate can, and will, change over time.
    • Your financial details: Specifically, lenders look at three numbers: your credit score, your debt-to-income ratio and your loan-to-value (LTV) ratio.
      • Credit score: You know the drill here. Higher is better.
      • Debt-to-income ratio: The debt-to-income ratio factors in all of your debts, like student loans or car payments, and compares them against your income. If too much of your money coming in is eaten up by debts, lenders will have concerns — and will usually charge you a higher interest rate. You want this ratio to be no higher than 36%, and lower is better.
      • LTV: This is the amount of money you’ll need to borrow (the loan) compared against the overall value of the house. Basically, it’s the size of down payment you’ll be able to make. A smaller down payment means a higher LTV ratio, which is riskier for lenders. As a result, you’ll get a higher mortgage interest rate.
    • Their own interests: Some lenders specialize in certain types of mortgages and, as a result, might offer you a better rate for those. Some lenders decide certain factors matter more than others (e.g., credit score over LTV). Ultimately, lenders will only fund a mortgage for you if they think it serves their best interest. The more optimistic they feel about you repaying your loan, the lower rate you’ll be able to land.

    You can’t shape a lender’s priorities or the market. You can, however, control your own financial profile and planning. Work on your credit score, pay off your other debts as much as possible and save up for a larger down payment. This will help you get the lowest mortgage rate possible.

    Do mortgage rates vary between lenders? 

    Mortgage rates do vary between lenders — and the differences can be significant. So how are mortgage rates determined from lender to lender? Each has its own underwriting guidelines, meaning it will look at specific things about you, your finances and your future home. All told, during underwriting, the lender is trying to decide if you’re someone who will reliably repay your mortgage. If they consider slightly different factors than another lender, they may offer you a slightly different rate.

    On top of this, some lenders work in niche markets. For example, if you have a less-than-ideal credit score, you might be able to get a lower rate by working with a lender who specializes in loans for people with poor credit.

    Lenders can also offer different rates for different loan products (e.g., 30-year fixed, 15-year fixed, 5/1 adjustable rate mortgages, investment property mortgages).

    [ Read: Best Investment Property Mortgage Rates ]

    To compare rates between lenders, make sure you’re comparing apples to apples. At the start of this year, for example, 30-year fixed rate mortgages had an average interest rate of 2.87%, while 15-year fixed rate mortgages had a much lower average interest rate of 2.34%. You’ll almost always get a lower interest rate for a shortage mortgage, so double-check that any mortgages you’re comparing have the same loan term.

    You’re also not stuck with the lender you originally choose. You can explore refinancing with a different lender down the road. The caveat here is that a refi usually comes with a new set of closing costs. In other words, it isn’t cheap.

    [ Read: Today’s Best Refinance Rates ]

    How the Fed’s decisions affect mortgage rates 

    As noted, many people think that the Federal Reserve’s funds rate determines mortgage rates. It doesn’t — not directly, at least.

    To better understand, it’s important to answer the question of how do interest rates work in general? It all comes down to how risky the lender perceives the loan to be. More risk means a higher interest rate.

    But when times are economically shaky, the Fed steps in to ease concerns. Otherwise, lenders might be more hesitant to loan money. That, in turn, would mean less purchasing across the economy, worsening the state of overall financial affairs.

    So how does the Fed help the situation along? It lowers its funds rate, or the rate at which banks can lend each other money. With this lower rate, money can flow more freely, keeping the economy moving.

    [ Read: How the Federal Reserve’s Decisions Affect Your Finances ]

    Because it affects banks’ access to money, the Fed funds rate shapes the prime lending rate, or the rate banks charge their most creditworthy customers. Mortgage lenders generally base their rates on the current prime lending rate.

    So, technically speaking, the Fed’s rate doesn’t directly touch mortgages at all. But because the effects of their funds rate trickles outward, it does impact a broad variety of lending programs. When that rate goes down, other rates — including mortgage rates — tend to follow.

    All this said, the Fed did directly impact mortgage rates during the COVID-19 pandemic. To shore up the economy, they bought more than $1 trillion in MSBs. The heightened demand for these mortgage bundles drove rates even lower, and those low rates were passed on to the buyers. That’s why we’re seeing such a huge uptick in home sales at the moment.

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    We welcome your feedback on this article. Contact us at inquiries@thesimpledollar.com with comments or questions.

    Kacie Goff

    Contributing Writer

    Kacie Goff is a personal finance and insurance writer with over five years of experience covering personal and commercial coverage options. Kacie founded Jot Content, a full-service content agency, in 2018. She lives in Ventura, CA, with her husband and dingo-look alike dog, Babou. When she’s not writing, you can find Kacie practicing yoga, working in her garden or scoping out a new happy hour.