How are mortgage rates determined?

Mortgage interest rates are often one of the most important factors at play when considering buying a home. The interest rate determines how much you will pay back in addition to the principal loan amount. Since that initial loan is generally a considerable amount of money, it only takes a fraction of a percentage to seriously affect what you will pay over the loan’s term.  

With so much significance over your financial future, it’s worth learning about some of the factors that determine mortgage rates nationally and on an individual basis. This can potentially help you eliminate some surprises when it comes time to take out a mortgage. In this article, we will discuss some of the macro determinants for mortgage rates as well as the conditions that affect your mortgage on an individual lender level.

Mortgage rate factors on a macro level

You may be familiar with headlines discussing mortgage rates rising and falling. Those generally refer to mortgage interest rates on a broader economic level. It must be stressed that the determinants of mortgage rates on an industry-wide level are many and complex.  

However, some of the factors generally include the following. We should also note that though historically rates may respond a certain way to certain inputs, that does not mean they will always respond the same way.  

10-year Treasury Notes

Mortgage rates, specifically for the 30-year mortgage, are generally directly impacted by rates on the 10-year Treasury note—even more so than by the federal funds rate (more on that later). Because 30-year mortgages are longer term loans, the 10-year Treasury note tends to be the better benchmark due to its long duration.  

Investors determine the rate for the 10-year Treasury note based on their expectations for short-term interest rates over that period. Those expectations are informed by monetary policy, fiscal policy, economic growth, and inflation.  

The Mortgage Spread

In addition to the 10-year treasury note benchmark, lenders will look at something called the mortgage spread when determining mortgage rates. This spread gets added onto the treasury note benchmark. So, what makes up the mortgage spread?  

• Primary-secondary spread. Typically, mortgages are securitized into mortgage-backed securities (MBS) and sold on secondary markets to investors. The primary-secondary spread is between the rate on mortgages offered to borrowers and the MBS rate. This is comprised of lender costs and profits pertaining to origination (servicing fees, guaranty fees). 

• Secondary spread. This is the spread between the MBS rate and the 10-year Treasury note. Responsible for that spread is, in general, the higher risk associated with an MBS versus a 10-year Treasury note. An MBS carries prepayment and credit risks and therefore tends to carry a higher interest rate than the 10-year Treasury note. 

The Federal Reserve

When you read about “rate cuts” in the news, there’s also a chance you’re hearing about the Federal Reserve’s federal funds rate. Fed cuts usually lead to lower mortgage rates, but that is not always the case. Last September, the Fed cut interest rates, but mortgage rates actually rose because of expectations for further inflation and economic growth. Ultimately, federal funds rates can be a contributing factor in mortgage rates, but they are not going to completely determine mortgage rates.  

Inflation

Talk of inflation has been another constant in the news. Inflation describes the increase in price of goods and services over time. The rate of inflation impacts the value of the dollar, and the value of the dollar can impact mortgage interest rates.  

Unemployment

Low unemployment tends to pair with economic growth, which can potentially mean more home purchases, too. If low unemployment leads to more home purchases, interest rates will often rise. Inversely, rates tend to drop when unemployment rises, as home purchases tend to slow down.

Mortgage rate factors for individual borrowers

When you apply for a mortgage, a number of your personal financial factors are reviewed by lenders to determine, among other things, the interest rate on your mortgage. Below are some of the things a lender will look at when assessing your loan application. But first, a few things to note: 

• This list, and the weight of each item, may vary from one lender to another.  

• Lenders look at the totality of your financial profile and the larger mortgage rate trends to determine your mortgage rate. This is to say, your final rate is more complicated than “bad credit score equals high interest rate.”  

• We are not talking about lender requirements here. Though lenders will likely have requirements overlapping with these categories that determine loan eligibility, we are just talking about how these can interact with interest rates. 

Credit Scores

Your credit score is one factor that tells lenders how likely it is that you’ll be able to repay the mortgage. Lower credit scores typically translate into a higher interest rate on your mortgage, and vice versa. It is not always that simple, but in general, it is a good thing to have a higher credit score when applying for a mortgage. Further, lenders generally have credit minimums that your credit score would need to clear to even be eligible for the mortgage.  

Debt-to-income ratio

Your debt-to-income (DTI) ratio is a measure of your monthly debt payments against your monthly income. For a mortgage loan, the lenders would include the mortgage in the debt payments. Lenders use DTI to determine whether you can afford the mortgage. A lower DTI generally works in the borrower’s favor, as it can potentially contribute to a lower mortgage rate.  

Down Payment and Loan-to-Value Ratio

Putting down a larger down payment can help reduce your mortgage rate. Lenders look at something called loan-to-value (LTV) ratio when determining mortgage rates for individual borrowers. A lower LTV can potentially contribute to a lower interest rate.  

LTV is a ratio comparing your total loan amount with the price of the home. So, putting down a bigger down payment can help you reduce this ratio by reducing the amount you need to borrow. For example, if you make a 10% down payment, you would then need to borrow the other 90% of the sale price from your lender. That means you’d have 90% LTV. 

Loan Amount

Larger loans might come with higher interest rates, as they can be riskier for the lender. You may also require a loan amount higher than the conventional loan limit for your area. In that case, you would likely be looking for a jumbo loan, and jumbo loans tend to have higher interest rates than conventional loans.  

Adjustable vs. Fixed-rate mortgage

An adjustable-rate mortgage (ARM) is a mortgage in which the borrower gets a fixed interest rate for a defined period at the beginning of the loan, after which the mortgage rate will adjust at set intervals. Fixed-rate mortgages give a borrower one set interest rate for the life of the loan.  

One reason that some borrowers might take on an ARM is that they can, at times, have lower initial interest rates than a fixed-rate mortgage might. However, it’s important that borrowers note that the initial interest rate on an ARM can potentially rise with each adjustment period. That’s why borrowers also tend to lean towards ARMs when they do not expect to keep the home past the adjustment period.  

Loan Type

The type of loan you take out can also impact your rates. For example, if the same borrower was looking at a conventional loan and was also eligible for a Veterans Affairs (VA) loan, that borrower might get a better rate on the VA loan. This could also be the case with other mortgage types that are insured by government agencies, such as the Federal Housing Administration.

Final Thoughts

Numerous factors coalesce to determine your mortgage rate. From factors beyond your control at an economic level down to your personal financial profile, that single percentage is the product of a lot of inputs—more than can be covered in this article.  

As you navigate your mortgage lending journey, it would be wise to focus on the factors you have more control over while staying informed about the bigger picture. Remember, mortgage rates can vary from one lender to another, so be sure to do your diligence when assessing lenders.