How Are Mortgage Rates Determined?

By Alvaro Moreira
7 min read

How Are Mortgage Rates Determined?

To help you find the best deal possible for your next home loan, it is important to learn how mortgage rates are determined. Saving just a fraction of a percent on your mortgage interest rate can end up saving you thousands of dollars over the life of the loan. If you know what affects mortgage rates, you will be better prepared when negotiating your home loan.

It is first important to note that no single element actually determines the mortgage interest rate that you will receive. Lenders will use a variety of factors to set your interest rate, some of which you can influence while others are beyond your control.

For instance, if you have a good credit score or opt for a shorter-term loan, you will probably get a lower mortgage interest rate. On the other hand, economic trends such as inflation are beyond your control. That’s why understanding mortgage interest rates and what makes them fluctuate are key to saving money on your home loan.

mortgage rates

What Factors are Within Your Control When Looking At Mortgage Rates?

1. Credit Score

Having and maintaining a good credit score will make a huge difference, because it shows mortgage lenders that you are responsible when it comes to paying your bills. People with higher credit scores generally get lower interest rates.

Here is one example of how that could play out, based on the February 2021 Mortgage Offers Report by Lending Tree:

  • Homebuyers with credit scores of at least 760 were offered 30-year, fixed rate loans at average annual percentage rates (APRs) of 2.86 percent.
  • Homebuyers with credit scores of 680 to 719 were offered average APRs of 3.09 percent for the same loan.

Based on the difference in APR, the second group of borrowers would end up paying almost $13,231 more over the life of the 30-year mortgage.

2. Down Payment

The higher your down payment, the lower your mortgage interest rate is generally likely to be since a bigger upfront payment reduces the risk on the part of the lender. A down payment of 20 percent or more translates to other benefits, which include eliminating the need for private mortgage insurance.

If you are able to put down at least 20 percent without impacting your budget too much, you may end up with lower monthly payments.

3. Loan Type

Conforming loans are the ones that Freddie Mac or Fannie Mae can purchase. Such loans typically have the lowest interest rates. If you are unable to put 20 percent as the down payment, however, you will be required to buy private mortgage insurance.

Non-conforming loans that can’t be sold to Freddie Mac or Fannie Mae, are not available from every lender. If you decide this route works best for you, try finding a mortgage interest rate that is competitive with the rates of conforming loans.

Federal Housing Administration (FHA) loans are targeted towards those whose credit is less than stellar. Such loans are backed by the FHA, via approved lenders, which helps keep down payment requirements low and interest rates reasonable. FHA mortgages, however, usually require annual mortgage insurance over the life of the loan.

Veterans Affairs (VA) loans, as their name might suggest, are available to both active-duty military members and veterans alike. There’s usually an upfront VA funding fee. The advantage to VA loans is that they don’t require down payments or private mortgage insurance, and they usually feature lower interest rates and fewer closing costs.

4. Mortgage Term

A 15-year mortgage will typically have a lower interest rate compared to a 30-year home loan. Freddie Mac listed the average interest rate for the 15-year, fixed-rate mortgage as 2.45 percent as of March 25, 2021 while the average interest rate for the 30-year, fixed-rate mortgage was 3.17 percent.

If you are in a position to take the shorter-term mortgage, you will pay less interest than you would if you had opted for the 30-year mortgage.

5. Location

Where you buy will make a difference because mortgage rates vary from one state to the next. For example, as of 25th March, 2021, the average 30-year mortgage rates in Connecticut stood at 3.79 percent, while in Colorado they stood at 4.04 percent.

People looking to buy homes in rural areas can take advantage of the mortgages the U.S. Department of Agriculture (USDA) offers. Interest rates for such loans are usually lower than other government-backed loans. USDA loans had a baseline rate of 2.75 percent as of March 2021. Some borrowers qualify for subsidies that lead to an interest rate drop to as low as 1.375 percent.

What Are the Factors Beyond Your Control?

1. Bond Yield Movements

A key indicator for U.S. home loan interest rates is the 10-year Treasury bond. The reason for this is that most mortgages are sold into the mortgage bond market, where they are converted into loan pools referred to as mortgage-backed securities (MBS).

When the yield on the 10-year Treasury notes is high, it is an indication that people are less interested in safe investments such as bonds, which leads to higher mortgage rates. Conversely, when the yield is low and many people are buying up bonds, mortgage rates usually decrease.

2. Federal Reserve Monetary Policy

The Federal Reserve typically adjusts the financial health of the nation by altering the federal funds rate, which is the short-term rate that banks charge each other. The adjustments, in turn, affect short-term interest rates for consumers on products such as savings accounts, checking accounts, as well as credit card APRs.

The Federal Reserve changes what it holds on its balance sheet to influence mortgage interest rates. The Federal Reserve currently has trillions of dollars in assets. About 64 percent of its assets are held in U.S. Treasury securities while about 29 percent consists of mortgage-backed securities.

The Federal Reserve buys and sells these assets thereby influencing how interest rates are set by mortgage lenders.

3. Inflation

Inflation has the potential to boost the 10-year Treasury note yield, since the Treasury rate includes an inflation expectation component. Once Treasury bonds go up, mortgage rates usually follow.

When do Mortgage Interest Rates Change?

Mortgage interest rates can change under several situations:

1. You pay for mortgage points at closing

Mortgage points, which are also referred to as “discount points” can lower your mortgage interest rate. Each point costs 1 percent of the mortgage loan amount.

You can determine if it’s actually worth it by dividing the cost of the point by the difference from the new and former monthly payments; the result will be the number of months it will take for the upfront money to pay for itself. If your plan is to stay in the home for significantly longer than that time period, buying points can make sense. Otherwise, it might be a good idea to pass. 

2. You have an adjustable-rate mortgage

A fixed-interest mortgage has a rate that remains unchanged during the term of the loan. The static nature of the monthly payment allows you to budget accordingly, without any surprises.

An adjustable-rate mortgage may be initially “fixed” (sometimes at a significantly lower rate than the 30-year fixed rates), but will change after a certain period that’s agreed upon in the loan document. After the interest rate resets, the loan may become unaffordable especially if the interest rates have gone up, especially if you have experienced a loss of income or faced some other financial challenge. Due to this reason, such loans are usually riskier than fixed loans.

Understanding Mortgage Rates: FAQs

Who sets mortgage rates?

The interest rates you receive are determined by mortgage lenders. Several factors determine mortgage rates, which include the loan type, mortgage term, inflation and bond yield movements. Some of the factors are within your control while others are at the whim of the overall market.

Why do mortgage rates vary by lender?

Mortgage rates vary from one lender to the next due to a variety of factors, one of which is the use of different risk-based pricing models. Lenders will assess borrowers and charge either lower or higher rates based on risk factors, such as the likelihood of a borrower to make timely payments. Lenders also have varying profit margins and operational costs, which may affect the rates they offer.

How frequently do mortgage rates fluctuate?

Mortgage rates can fluctuate daily, but you will typically see averages posted once weekly at sources such as Freddie Mac.

How do I find the best mortgage rate?

The best way to find the most competitive mortgage rates based on your financial situation is to get quotes from multiple lenders. When you do, ensure that you carefully examine the loan estimate document to find out how much you will be paying. If you are a first-time home buyer, most states have programs offering below market rates to accelerate your path to owning a home.

Are mortgage rates and refinance rates different?

Yes. Starting December 1st, 2020, Fannie Mae and Freddie Mac implemented an extra 0.5 percent adverse market fee on mortgage refinances. Still, your final rate will depend on the lender along with other components, such as your debt-to-income ratio, credit score, and your loan balance if it is a mortgage refinance.

How can I lower my mortgage rate?

Purchasing discount points is a great way to lower your rate. Each point costs 1 percent of the loan amount and can lower your rate by 12.5 to 25 basis points. For example, if your loan amount is $300,000, each point costs $3,000.

Should I lock my mortgage rate?

Since the mortgage rate is not guaranteed, it can be advisable to lock it without delay to avoid being caught off guard. Ensure that you compare multiple quotes before you do so. Other scenarios whereby it can be advisable to lock in your mortgage rate would be if you are closing on a home soon, you have enough income and assets to proceed with the closing process, and you have already sold your existing home.