Mortgage Rate Factors: How are mortgage rates set?

When it comes time to purchase a home or refinance an existing mortgage, most of our clients, for obvious reasons, start to think and ask questions about interest rates.  Mortgage rates play a crucial role in the overall affordability of a home since they are one of the main determinants of monthly mortgage payments.

We all know that lower mortgage rates are good, and higher mortgage rates are bad, at least when we look at it with just the narrow focus of our mortgage rate. But what makes them go up and down? This article will give you some insight into how mortgage rates are set and what factors cause rates to move. 

Main Factors That Influence Your Mortgage Rate

·         Economic Conditions

·         Federal Reserve Polices

·         Mortgage-Backed Securities

·         Your Personal Finances

·         Loan Characteristics

Economic Conditions

Global and United States economic conditions will determine rates and borrower costs across all types of rates, including mortgages. In a thriving economy, rates generally rise, and when conditions weaken, rates will generally decline. We don’t have to look too far back in history to see both ends of the economic spectrum and how rates were impacted. During the pandemic in 2020, when the economy nearly came to a halt, rates plummeted to the lowest levels in history. And as the pandemic subsided and the economy quickly rebounded, rates quickly moved to the highest levels in nearly 20 years.

Inflation, as we have learned (or relearned depending on your age) is one of the byproducts of an overheated economy. When rates are too low for too long or the supply of money is too great, inflation causes the price of our goods and services to skyrocket. And it’s not only the cost of the goods or services that goes up, but the cost of borrowing money as well.

Federal Reserve Policies

The Federal Reserve’s (FED) mandate is to promote maximum employment and stable prices throughout the US economy.  In other words, the FED strives to find the balance of a strong economy and labor market without overheating the economy to a degree where inflationary conditions cause prices to rise too fast. 

One of the primary tools of the FED is its ability to set the Federal Funds Rate – the interest rate at which banks charge each other to meet their reserve requirements. The Federal Reserve adjusts the Federal Funds Rate to help balance economic conditions – lowering rates to stimulate economic growth or raising rates to cool down the economy or fight inflation.

While the Federal Funds does not directly impact your mortgage rate, it does have an immense impact on the bond market where mortgage-backed securities are traded.  

Mortgage-Backed Securities

Mortgage-Backed Securities (MBS), or mortgage bonds, are quite simply bundles of mortgages that are pooled together and sold on the bond market. The bonds are considered low risk, safe investments for institutional investors, which is why they generally trade in concert with other similar low risk investments like US Treasury Bonds.

It is important to understand the correlation between the underlying loans that make up an MBS and the yield paid to the owners of the mortgage bonds. The interest paid on the underlying loans becomes the yield, or return, paid to the mortgage bond owners.

Like any other asset, the price of a mortgage-backed security is determined by supply and demand. When the demand for MBS is high, the yields (and interest we pay on mortgages) go down. When demand is weak, the yields on MBS goes up in order to attract investors back to MBS.

During times of economic booms, investors will likely move their money to higher yielding, more speculative assets like stocks or equities. MBS yields will have to increase. Interest rates on new originations will increase in order to be packaged into the higher yield mortgage bonds.

However, the opposite occurs during uncertain times or periods of economic downturn. Mortgage-backed securities become popular assets - demand increases, yield decreases, and mortgage rates drop.  

Your Personal Finances

Ok, so all of that economic talk is great, but what about your ability to control the mortgage rate you get? You most likely can't control the US economy, so let’s focus on things you can control. Here are a few ways to put yourself in a position to get the best rate possible when it’s time to borrow money for a home purchase or refinance.

Credit Score

Your credit score is one of the most critical factors in determining your mortgage rate. Lenders assess credit scores to evaluate the risk of lending money to a particular borrower. Higher credit scores indicate lower risk, leading to lower mortgage rates. Meanwhile, borrowers with lower credit scores may face higher rates due to the perceived increase of default risk.

Before applying for a loan, make sure your credit score is in the best possible shape it can be. To learn more about credit scores, check out our Credit Scores Learning Center.  

Down Payment/Equity

The size of the down payment or amount of equity in your home can significantly impact your mortgage rate. A larger down payment reduces the lender's risk because it demonstrates the borrower’s financial commitment and provides the lender with more security.

Take a look at various down payment options when it comes time to purchase a home. There are many loan types with various down payment requirements to fit your needs. If you are interested in the various loan types and their down payment requirements, check out our Home Buying Learning Center.

Debt-to-Income Ratio (DTI)

The debt-to-income ratio (DTI) measures a borrower’s monthly debt payments against their gross monthly income. A lower DTI indicates that a borrower has more disposable income available, which reduces the lender’s risk. While not all loans will adjust the rate based on a higher DTI, it can cause your rate to increase in some extreme scenarios.

If you would like to know how lenders determine DTI, check out Debt-to-Income Ratio: What Counts Against Me? 

Factors that can positively impact your mortgage rate

·         Higher Credit Scores

·         Lower Loan to Value – more down payment and/or equity

·         Lower Debt-to-Income Ratio

·         Shorter Loan Terms

·         Loan is used to purchase a home or lower your current rate

Factors that can negatively impact your mortgage rate

·         Lower Credit Scores

·         Higher Loan to Value – little down payment and/or equity

·         Higher Debt-to-Income Ratio

·         Longer Loan Terms

·         Loan is used to get cash out of your home 

Loan Characteristics

Beyond your personal finances, the characteristics of your loan can impact your mortgage rate.

Loan Type

Different types of loans come with varying rates. For example, fixed-rate mortgages tend to have higher rates than adjustable-rate mortgages (ARMs) at the start, but ARMs can fluctuate over time, potentially leading to higher costs in the long run. Borrowers should consider their financial situation and risk tolerance when choosing between these options.

Loan Term

The length of the mortgage term also affects the interest rate. Shorter-term loans (e.g., 15 years) generally have lower rates than longer-term loans (e.g., 30 years). This is due to the diminished risk that lenders face with shorter loans, because the loans are paid back more quickly.

Loan Purpose

The purpose of the loan has an impact on the rate as well. Loans used to purchase a home or to pay off an existing loan have better rates than loans that are used to get cash out of your home. Tapping into your equity can be a smart solution depending on your situation, but rates are generally a bit higher on cash out refinances.

How I Can Help You

When it comes time to purchase a home or refinance an existing loan, I want to help you! Hopefully articles like this give you good information and a better understanding of the mortgage world, but let me use my experience and expertise to help you with your particular situation.

I tell my clients and referral partners that a mortgage transaction starts with a simple conversation. Let’s talk about your financial situation, budget, and goals so that I can help you determine the best solution for you. During a 10-minute informal conversation, we can get you on the right path as it relates to a home purchase or mortgage refinance.