How Are Mortgage Rates Determined? Factors That Affect Mortgage Interest Rates

When you apply for a mortgage or refinance your home, you may already know you'll get an interest rate – it's part of the package. But how are mortgage rates determined? Furthermore, who sets them, and what are the factors that affect mortgage rates?

It's a great idea to understand the combined market and personal factors that set mortgage rates because these affect your monthly payments and the amount you pay over your loan term. You want to ensure that you know what you'll pay over your loan term, and you can influence some of the factors that affect your interest rate.

Read on for more information about determining mortgage rates.

What Determines Mortgage Interest Rates?

First, what exactly are mortgage rates (before we dig into the answer to "how are mortgage interest rates determined")? They are the amount of interest a lender charges for a mortgage. They can be fixed or adjustable, meaning they can either stay the same throughout the life of the loan or they can fluctuate over time.

Mortgage rates influence your mortgage payment – the larger the interest rate, the larger your monthly mortgage payment and the more interest you'll pay over your loan term. The type of mortgage rate you get depends on your home loan type, lender, qualifications and more.

So, what determines mortgage rates? Many factors affect your individual mortgage rate, including personal factors – credit score, down payment, loan-to-value ratio (LTV). You can largely control these factors. Other factors (which you cannot control) also affect mortgage interest rates – namely, market factors.

Fixed- And Adjustable-Rate Mortgages

Fixed- and adjustable-rate mortgages can yield markedly different interest rates.

Because the interest rate doesn't change on a fixed-rate mortgage and because your payment stays the same throughout the life of the loan, fixed-rate mortgages are the most popular types of mortgages available. Here's an example of how it works. Say you choose a 30-year fixed-rate mortgage (the most popular loan term).

After 30 years, your loan is fully amortized – that is, it's fully paid off. You'll also know exactly how much you pay in interest each month due to your regularly scheduled monthly payments in even amounts.

On the other hand, adjustable-rate mortgages (ARMs) differ from fixed-rate mortgages because the interest rate is not fixed. ARMs typically have a lower interest rate than fixed-rate mortgages during an initial fixed-rate period of the ARM (usually 5, 7 or 10 years), but after the initial period, the rate and payment can fluctuate depending on changes in the benchmark market index.

Again, interest rates for ARMs are usually lower at the beginning. Lenders charge a slightly higher interest rate for fixed-rate loans because they must account for future interest changes.

Who Sets Mortgage Rates?

No single entity on its own sets mortgage rates – think of it as a collection of factors that help determine your rate. However, the Federal Reserve does have a heavy hand in influencing rates. Learn more about the Federal Reserve’s role in greater detail in the section below.

What Market Factors Affect Mortgage Interest Rates?

Several market factors determine interest rates, including the Federal Reserve, the mortgage bond market, the economy and inflation.

The Federal Reserve

The Federal Reserve is the central bank in the United States. The Federal Reserve (the Fed) doesn’t set interest rates, it just influences them. The Federal Reserve changes short-term interest rates up and down based on economic cycles. The prime rate for mortgages usually changes when the Federal Reserve makes adjustments, and banks and lenders must mirror these changes.

The Mortgage Bond Market

The mortgage bond market is a financial market where participants can issue new debt or buy and sell debt securities. Mortgage-backed securities, also called mortgage bonds, are mortgages sold on the bond market in bundles. When mortgage bond prices are high, mortgage rates decrease, and when the price is low, mortgage rates increase.

The Economy

Changes in the economy also affect mortgage rates. Good and bad economic news impact the direction of mortgage rates. Good economic news (like low unemployment and positive economic growth) can cause mortgage rates to increase. Bad economic news like recessions and high unemployment can cause mortgage rates to drop.

Inflation

Inflation occurs when the price of goods and services increase over time, leading to a loss of purchasing power. Mortgage interest rates typically increase to keep up with the value of the dollar when inflation increases.

Individual Factors That Affect Mortgage Rates

Certain personal factors also determine a borrower's individual mortgage interest rate. Unlike the economy or the Federal Reserve, these factors are more within your control. These factors include your credit score, LTV, down payment, mortgage term and type of home.

How are mortgage interest rates connected to these personal factors? Let's find out.

Your Credit Score

Your credit score, a three-digit number that shows how well you make payments and have handled debt recently and in the past, can affect your mortgage interest rate. Credit scores typically range from 300 – 850. You may be able to qualify for a mortgage with a credit score of 580, but lenders view a good credit score more favorably than a low credit score. A higher credit score will give you a better interest rate on your mortgage.

You can improve your credit score by making your payments on time, catching up on past-due accounts, paying down revolving account balances and limiting credit applications.

Your Down Payment

A down payment is the amount you put down upfront for your home at closing. The down payment reduces the amount you'll have to borrow from your lender. The amount you put down can help a lender determine your interest rate.

For example, a larger down payment may mean you can qualify for a lower interest rate. A lower down payment could result in a borrower paying private mortgage insurance (PMI), a type of insurance that helps the lender recoup costs if borrowers end up defaulting on the mortgage. Down payment directly affects your loan’s LTV, discussed below.

Your Loan-To-Value Ratio

Your LTV, a percentage that compares your loan amount to the appraised value of the property you want to buy, also affects your mortgage rate. You can calculate it yourself by dividing your total loan amount by the property's appraised value, converting that to a percentage.

Although you may be approved with an LTV as high as 100%, typically lenders like to see an LTV of 80% or lower. With a lower LTV you have a better chance of qualifying for a better interest rate.

Mortgage Term

The mortgage term you choose – such as a 30-year or 15-year – affects your mortgage interest rate. Generally, the longer your loan term, the more you'll pay in interest. Shorter loan terms usually carry a lower interest rate, whereas higher loan terms typically carry a higher interest rate.

Most lenders offer a 15- or 30-year mortgage, though some lenders offer 10- or 20-year mortgages. Check with your lender for more options.

Loan Type

Your loan type also determines your interest rate. For example, if you choose a non-government-backed loan (a conventional loan) or a government-backed loan (FHA, USDA or VA loan), you could pay different mortgage interest rates for any of these. In government-backed loans, the government guarantees the loan, meaning that it backs the lender if a borrower defaults on the mortgage.

A jumbo loan, on the other hand, is a type of loan that goes beyond the limits set by the Federal Housing Finance Agency (FHFA). These generally carry higher interest rates than conventional loans, which are not government-backed but also fall into the guidelines set by the FHFA.

How Are Mortgage Rates Calculated?

Although there is not a specific formula for determining interest rates, widely available tools such as online mortgage calculators give you a good starting point for what you can afford. Lenders typically give current mortgage rates on their websites that you can plug into a mortgage calculator, along with your loan amount and down payment. For example, you might be trying to decide between a $250,000 15-year mortgage loan at 6% and a 30-year mortgage loan at 7%. Which is cheaper? A mortgage calculator can help you determine whether a particular mortgage rate fits your situation. Then, for the most accurate interest rates that you qualify for, contact your lender and consider getting preapproved for a mortgage.

The Bottom Line

No one entity sets mortgage rates that you will qualify for. Certain factors help determine your rate, such as the Federal Reserve, the mortgage bond market, the economy, inflation and factors that are specific to you, such as your credit score, down payment, LTV, mortgage and loan term. You can help improve your qualifying mortgage rate by doing things like improving your credit score or making a larger down payment.

Your lender will help you understand all your options, particularly when it comes to your mortgage rate. You can also use a mortgage calculator to figure out what your payments might be, depending on your loan term and possible interest rates.

Ready to find your next home? Start an application today with Rocket Mortgage^®.