How Mortgage Rates Are Determined: A 2022 Guide

By Alvaro Moreira
8 min read

There are many factors that come into play when it comes to determining mortgage rates. These factors include overall economic health and personal factors like credit score, the size of the loan compared to the value of the property, and how you occupy your home. 

Many people think about the mortgage market when they want to buy or refinance a home. a mortgage is a home loan from a lender like a bank or financial institution. If you don’t know that much about mortgages, then you might be thinking that there is some sort of mysticism involved that mere mortals can’t understand.

This post is going to look at these factors in detail so that you can know how mortgage rates are determined and what you can do to get a good rate.

mortgage rates

Market Factors Determining Mortgage Rates 

Before looking at personal factors, there are many factors that affect mortgage rates in the financial markets. This includes the impact from the bond market, and also the Federal Reserve. The overall economy is also going to have a hand in this.

How the Bond Market Affects Mortgage Rates

We don’t see it this way because a home is seen as being personal for everyone, but mortgages at the end of the day are a big financial instrument. Investors can trade mortgages, just like with most finance products out there. The mortgage bond is how home loans are traded.

They are also referred to as mortgage-backed securities (MBS). Loans with the same characteristics such as credit score, down payment amount, and the original investor in the loan (Like Freddie Mac or Fannie Mae or government investors like VA or FHA) are put together to become mortgage bonds.

You are going to be bucketed into an MBS based on your personal characteristics. Investors looking at bonds are going to decide on the bonds to buy based on the rate of return and their risk tolerance.

If you happen to end up in a category with better financial characteristics, there is a good chance you are going to make a payment to a person with a riskier profile. There is a trade-off here, the interest rate (and also the investor return) is going to be lower compared to other borrowers.

It is more than personal factors. One of the things to keep in mind is that bond markets are seen as a safer place to put your money compared to other investment options like the stock market. The stock market can give a higher return, but there is a lot of volatility and an investor can suffer when there is a downturn. With bonds, you have a guaranteed yield. 

Mortgage rates tend to go down when people are buying mortgage bonds. This is because the rate on the bond doesn’t need to be high for it to attract investors. When money is moving away from MBS and going to stocks or other types of investments, the mortgage rates can go up so that investors are attracted to it.

The Federal Reserve and Mortgage Rates

The work of the federal reserve is to maintain a stable rate of inflation. They do this using something known as the federal funds rate. The Fed Funds Rate is the rate at which banks borrow money from one another overnight.

When they control the amount being borrowed from each other, the Fed is going to easily control the money supply. When the short-term interest rates are low, it is cheaper to borrow money, which is going to result in an increase in the money supply in the market, and this causes the price to go up. When the rates are higher, less money is there, which causes the prices to drop.

The Federal Reserve has kept the rate at near 0% because of the pandemic. This has led to the mortgage interest rates remaining low.

When the Fed Reserve keeps the rate low, it is going to cause an increase in inflation with time. This has not been the case so far. Inflation has been short of the 2% annual goal for the last couple of years. The rate spiked to 6.2% in October 2021.

The Fed likes it when the prices go up a little bit every year because it is good for the economy because it pushes people to buy now instead of waiting, especially when they think that the prices are most likely going to rise in the future.

The Overall Economy and Mortgage Rates 

Both the overall markets and the Federal Reserve react to the ups and downs of the economy. Below are some examples.

When people think that they are prosperous times now, they are going to move money to stocks because they offer higher returns away from bonds which have lower returns. This causes the mortgage rates to increase. If investors believe there is a downturn coming, they move their money to bonds and this causes the mortgage rates to drop.

Inflation is also going to affect mortgage rates. Higher inflation incentivizes people to put their money in stocks. This is because they see the guaranteed return from bonds being eaten by the rise in inflation.

When the bond is giving you 5% and the money supply increases by 3%, it means that the effective return is just 2%. One thing to keep in mind is if you have a fixed-rate mortgage, you are going to pay the same and inflation won’t change it. 

Unemployment also has an effect on mortgage rates. If more people are unemployed than what the Fed thinks is okay, they usually reduce the interest rates to encourage borrowing, which can then be used in growing the workforce.

Personal Factors and Mortgage Rates

There are many factors unique to you that are going to affect mortgage rates. Some of them include the equity or down payment amount you are bringing in, your credit score, and how you plan on occupying the home. What you want to accomplish is also going to affect the interest rate.

Credit Score and Mortgage Rates

Investing and lending in mortgages involves the rate of return you are going to make and the risks involved when funding the loan. A credit score is an important tool used by lenders to assess the risk of a client.

If everything was to be the same, the higher your credit score, the longer your history of making payments on time. When investors see someone with a good score, they know there is less risk of default. This is why you can expect to get a lower rate compared to someone who doesn’t have a good credit score.

There are three credit bureaus, and the score that is used is the lowest median score of all clients on a loan. If your median score is 640 and your partner has 620, then 620 is the one that is going to be used for the loan.

Down Payment and Mortgage Rates 

The down payment you are making or the amount of existing equity you have in the home when refinancing is going to have a big impact on your mortgage. When you make more in down payment, the less the lender has to give you to buy the property, which means that there is a lower risk. This is going to make them offer you a lower mortgage rate.

If you want to make a down payment of less than 20%, you will need to pay for mortgage insurance if it is a conventional loan. There are two options when it comes to mortgage insurance; lender-paid mortgage insurance and borrower-paid mortgage insurance. You have to pay a monthly fee when you choose the borrower-paid mortgage insurance. When you choose the lender-paid mortgage insurance, you are going to get a higher mortgage rate, which is going to affect how much you pay monthly.

When investors are choosing the mortgage funds to invest in, the loan-to-value ratio is used to label it. An easy way of thinking about LTV is it being an inverse of your equity amount or down payment. If you want to calculate LTV, take your equity amount or down payment then subtract it from 100. If you make a 5% down payment, then the LTV is 95%.

Occupancy and Mortgage Rates 

Another thing that is going to affect the mortgage rate is the plan you have on occupying the property. Are you buying it as a primary home, investment property, or a second or vacation home?

If the property is your primary home, you are going to get the lowest rate. Vacation homes usually attract a slightly higher rate. This is the same for investment properties. This happens because the lenders look at the risk.

When someone is in financial trouble, they are always going to prioritize payments on their primary residence before thinking about their second or vacation home. You are also going to make the payments on your vacation home before the rental property that you don’t live in since you don’t have an attachment to the building apart from collecting the rent.

Taking Cash Out and Mortgage Rates 

If you want to convert home equity into cash, you are going to get a higher rate compared to buying or refinancing for the sole purpose of lowering your rate or changing your loan term. This is because you will take a higher balance than what you had when getting into the transaction, which leaves the lender and mortgage investors with more risk.

What Determines Mortgage Rates? 

Before confirming a mortgage rate lock, you need to know about the market-based and personal factors that are going to have a hand in determining your mortgage rate. You cannot remove any of them from this process.

When it comes to the market side, the biggest direct influence is going to be the bond market because MBS provides funding for the mortgages and where the bonds are traded. This market is also going to be affected by the moves made by the Federal Reserve and they are going to act a given way depending on the overall economy.

Apart from the movement in the market, the personal financial situation is also going to affect the mortgage rate. Personal factors are going to determine the risk associated with mortgage-backed securities. The factors include credit score, how the borrower plans on occupying the property, the level of existing equity, or the purpose of getting the mortgage.