Exactly how are mortgage rates determined? You might think it’s a lot of smoke and mirrors, but it’s actually not. There are many factors that impact mortgage interest rates and how much your mortgage payments will be when buying a home or refinancing an existing mortgage. The lower your interest rate, the lower your payments will be. 

You can control some of these factors, like your credit score, debt-to-income (DTI) ratio, and down payment. There are also several factors you can’t control, like inflation, bond yields, Federal Reserve monetary policy, and more. 

We’ll start with the factors you can’t control to give you a better idea of the market forces that impact interest rates. Then, we’ll go over factors you can control so you know how to improve your chances of getting the best mortgage rate possible. 

Mortgage Rate Factors You Can’t Control 

Some of the factors that affect the mortgage-rate environment are complex, so we won’t get into all the details below. Here’s a high-level overview of five major variables:

1. Inflation

Inflation, inflation, inflation... It’s a hot topic that gets a lot of attention. In a nutshell, inflation is an increase in the price of goods and services over a certain timeframe. Inflation is a normal part of the economy, but it’s most noticeable when it’s high and prices increase quickly, especially in areas like groceries, gas, and housing. Your money doesn’t go as far as it used to, which is known as decreased purchasing power. Higher inflation typically leads to higher interest rates. That’s because higher prices also impact mortgage lenders, so they increase rates to ensure they don’t lose money. When inflation is low, mortgage rates often stay fairly steady. 

2. The Economy

When the economy is stronger and faster growth is expected, mortgage rates often rise. Economic growth brings higher wages, lower unemployment, and more consumer spending, including an increase in the number of consumers wanting mortgages to buy a home. That increased demand leads to higher inflation, which tends to make mortgage rates go up. When the economy slows down, mortgage rates often fall. 

3. Federal Reserve

The U.S. Federal Reserve (Fed) doesn’t set mortgage interest rates, but it does set short-term interest rates that influence financial markets. These short-term interest rates are known as the federal funds rate, which is what it costs banks and lenders to borrow money. Banks and lenders use this as a baseline for the annual percentage rate (APR) you’re charged for a loan. The Fed manages these short-term rates to influence the money supply, such as raising rates to try to control inflation by making it more expensive to borrow money. This indirectly affects mortgage loan rates. If rates go up, mortgage rates tend to rise. 

4. The Bond Market

The interest rate lenders charge for fixed-rate mortgages is affected by mortgage-backed securities, which are often closely linked to U.S. Treasury bonds, particularly the 10-year Treasury note. Individuals and organizations buy bonds as an investment. Similar to a savings account, they receive interest over the time duration that they hold the bond. When the yield (interest rate) that is paid on the 10-year note rises, mortgage rates usually also rise. When Treasury yield falls, mortgage rates typically fall. 

Adding another layer, mortgage-backed securities are bundles of home loans sold on the bond market. These mortgage bonds compete for investors with yields on the 10-year note. Yields from mortgage bonds need to be high enough to attract buyers. Because they have higher risk than government bonds, they need to offer higher yields. That’s why mortgage interest rates are closely tied to moves in the yield of the 10-year Treasury note. 

Note: bond prices don’t affect the interest rate of adjustable rate mortgages (ARMs). They are affected by the Secured Overnight Financing Rate set by the U.S. Treasury. 

5. Housing Market Conditions

The housing market itself can also affect mortgage rates. High demand for housing and low housing inventory can make home prices go up, which can potentially lead to higher interest rates as lenders compensate for higher risk. Economic indicators that give a look at the health of the housing market can also affect loan rates. These include home sales, housing starts, and home price indices. 

Factors You Can Control 

While the five factors mentioned above regarding how mortgage rates are determined are beyond your control, there are multiple personal factors that you can control. One of the main personal factors mortgage lenders consider to help determine your mortgage rate is how likely you are to repay the loan. This is based on how you’ve managed your finances, which includes your credit score, savings, income, and amount of debt. 

Lenders have extensive data and history making loans, so they know that having a higher credit score and making a larger down payment generally reduces their risk that the borrower won’t be able to make their mortgage payment. That’s why borrowers who lenders determine to have the lowest risk will often get the lowest rates.  

Here are some of the main factors you can control that will position you to get the best rate possible for your financial situation: 

1. Credit Score

Your credit score is probably the most important factor that’s within your control. This number is based on variables like how much debt you owe, your history and timeliness of repaying debt, the amount of credit available to you, and more. Lenders see a higher credit score and judge you as a responsible borrower with a lower risk of defaulting on your mortgage. Good or excellent credit scores (690-720+) will usually receive lower interest rates. 

The good news is that if your credit score doesn’t fall in the higher range, you can work to improve your score before buying a home. That could be worth it because even a small difference in the interest rate can reduce monthly payments and make a significant impact on the amount of interest paid over the life of the loan. 

There are also government-backed programs for borrowers with lower credit who don’t qualify for a conventional loan. These include FHA, VA, and USDA loans. 

2. Loan-To-Value (LTV) Ratio

The loan-to-value (LTV) ratio is a measurement of the loan amount compared to the appraised value of a home. The LTV ratio is directly tied to the amount of the down payment. A 20% down payment equals an 80% LTV ratio. Ratios greater than 80% are considered high and could lead to a higher mortgage rate. The larger the down payment, the lower the LTV ratio will be and you’ll typically be able to get a lower rate. That’s because a lower LTV means less risk to the mortgage lender. 

Here’s an example of how to calculate LTV: if you make a $40,000 down payment on a $200,000 house, the mortgage would be $160,000. That means you’re borrowing 80% of the home’s value, so your LTV ratio is 80%. With LTV ratios above 80%, you would likely have the added expense of being required to pay for private mortgage insurance (PMI). 

With a refinance, the loan-to-value ratio also plays a role. In the case of a refi, it compares your current mortgage balance to the appraised value of your home. It’s best to have an 80% LTV ratio or higher.  

3. Debt-To-Income (DTI) Ratio

Your DTI ratio is the sum of all of your monthly debt payments divided by your gross monthly income (that’s income before taxes). It gives lenders a better idea about your financial stability and the ability to manage debt and be able to make your monthly mortgage payments. Just like with your LTV ratio, lower is better. In the case of DTI, a 36% or lower ratio typically helps you get access to the lowest rates because it demonstrates your ability to manage debt responsibly. Most conventional loans allow for a DTI of no more than 43%. 

4. Occupancy

Whether your home is a primary residence, secondary residence, or investment property will also impact your mortgage rate. Interest rates on a primary home will usually be lowest because that’s where someone lives the majority of the year and mortgage lenders consider them less risky. If a borrower experiences financial hardship, they’re more likely to keep making payments on their primary residence first. Borrowers experiencing financial hardship would historically be less likely to keep paying on their secondary residence or investment property, so interest rates tend to be higher for these types of properties. 

Other Factors 

There are other factors that are within your control that can help determine your mortgage rate. They include the loan amount, loan term (i.e., 30-year mortgage, 15-year mortgage), closing costs, discount points (paying an upfront fee to reduce the interest rate), and fixed rate or adjustable rate mortgage. 

Now that you know more about how mortgage rates are determined, you can work on getting your financial situation in order if it’s not as strong as it could be. The two best ways to do that are to improve your credit score and to save for a larger down payment. By understanding all of these factors, you’ll be better positioned to get the best mortgage rate possible. 

If you think you’re ready to move ahead with buying a home or refinancing your current home, contact us today to get started. 

The information provided here is for informational purposes. When interest rates and loan program information are included, it is for illustration purposes only and not a solicitation or quote for services. This is not an advertisement or loan estimate. Current interest rates, loan programs and qualification criteria can change at any time. If you have questions or need assistance, we can be reached using the contact information above.