If you’ve been on the edge of your seat watching mortgage rate gyrations in recent weeks, you’re not alone. Homebuyers and homeowners looking to refinance have sprung into action to take advantage of lower rates, which helps offset housing affordability challenges as home prices continue to creep up.
But why have rates moved sharply lower and, more broadly, what drives mortgage rate movements? The answers are slightly complex, but will make sense after we explore what does (and doesn’t) drive mortgage rates. Grab a seat for a quick crash course that could save you money on a new mortgage or a refinance.
1. It (sometimes) begins with the Federal Reserve
The Federal Reserve doesn’t set mortgage rates but, sometimes, their decisions can indirectly influence them. The Fed’s rate decisions typically impact shorter-term products, like credit cards or home equity lines of credit, says Greg McBride, CFA, Bankrate’s chief financial analyst. Meanwhile, mortgage rates move based on longer-term interest rates.
“It’s the longer-term outlook for economic growth and inflation that have the greatest bearing on the level and direction of mortgage rates,” McBride says. “Because mortgages are packaged together into securities and sold as mortgage bonds, it’s the return investors demand to buy these bonds that dictates the general level of mortgage rates.”
Mortgage rate levels are priced above that of the 10-year U.S. Treasury, considered by investors to be a risk-free investment The spread in pricing between mortgage rates and the 10-year Treasury reflects the risk that investors bear for holding those bonds, McBride adds.
“It may seem counterintuitive that 30-year mortgage rates are priced relative to yields on 10-year Treasuries,” McBride says. “But when these 30-year mortgages are packaged together into bonds, on average, they tend to pay out over a 10-year period as homeowners refinance, move or otherwise pay off their loans early.”
2. Economic conditions have a role in mortgage rates
What happens in the economy and, specifically, how those events impact investors’ confidence, influences mortgage pricing. Oddly, though, good and bad economic news have an opposite impact on the direction of mortgage rates.
“Bad economic news is often good news for mortgage rates,” McBride says. “When concern about the economy is high, investors gravitate toward safe-haven investments like Treasury bonds and mortgage bonds, pushing bond prices higher but the yields on those bonds lower.”
Good economic news — increases in consumer confidence and spending, positive GDP growth and a solid stock market — tend to push mortgage rates higher. That’s because the higher demand means more work for lenders who only have so much money to lend and manpower to originate loans, says Jerry Selitto, president of Better.com, an online mortgage lender.
3. That sleeping giant called inflation
Inflation is the prolonged increase in the pricing of goods and services over a period of time, and is an important benchmark when measuring economic growth. Rising inflation limits consumers’ purchasing power over time, and that’s a consideration lenders make when setting mortgage rates.Lenders have to adjust mortgage rates to a level that makes up for eroded purchasing power when inflation rises too quickly. After all, lenders still need to make a profit on the loans they originate, and that becomes more difficult when consumers’ buying power is diminished. Likewise, inflation is a consideration investors make in the prices they’re willing to pay for loans, and the returns they demand, on mortgages and other bonds they purchase on the secondary market.
4. Origination costs (so lenders can keep the lights on)
A key consideration lenders make when pricing home loans is the cost of originating said mortgages. That includes tasks such as running a credit check, underwriting, checking title and the many other steps a lender must take to process a loan.
Tighter lending regulations implemented after the 2007 housing crash have cut into lenders’ profits as they’ve changed their systems to comply with new regulations, Selitto says. That’s pushed the cost of originating mortgages higher. In the fourth quarter of 2018, the cost to originate a mortgage rose to $8,611 per loan, up from $8,174 per loan the previous quarter, according to data from the Mortgage Bankers Association. That’s a steep increase over the production costs of $6,224 per loan that lenders averaged from 2008 to 2018.
“In setting prices, lenders have to look at the cost of origination and decide what margins they want above those costs,” Selitto says. “The more efficient a manufacturer of mortgages can be, the more competitive they are on pricing.”
5. Your financial and credit picture
Lenders have to ensure you can repay your mortgage, and they do that by assessing your risk of default. Lenders pay close attention to your debt-to-income, or DTI, ratio, and your credit score. Your DTI ratio is the sum of all of your monthly debts (including the new monthly mortgage payment) in relation to your gross monthly income.
Generally, the higher your DTI ratio, the riskier you appear (on paper) to a lender — and the higher your interest rate will be. As a general rule of thumb, conventional lenders want to see your DTI ratio stay below 43 percent, but some loan programs will consider borrowers with a DTI ratio as high as 50 percent.
Your credit score is another indicator of your ability to manage debt and pay bills on time. Borrowers with a lower credit score pay higher interest rates and have more-limited loan options if their credit is less-than-stellar.
As mortgage rates fall, your DTI ratio falls, too, because a lower rate will drop your monthly mortgage payment, which is included in your DTI ratio calculation. As a result, you could afford to buy more house, Selitto says.
When demand for mortgages surges, lenders may have to account for the spike in demand — and the processing costs involved — by hiking mortgage pricing. Likewise, when demand is flat or falls, lenders have to adjust pricing to attract business and keep the lights on, Selitto says.
Mortgage rates are always a moving target. They change hourly, daily and weekly, and are difficult to time perfectly. If you’re weighing a home purchase or refinance, it’s a good idea to shop with multiple lenders to compare mortgage rates and find out when you should lock in your loan.