How are mortgage rates determined? Here’s what drives mortgage interest rates

It’s been a wild ride with mortgage rates of late: plunging to record lows during the pandemic, then doubling to 20-year highs in 2022. Now, they seem poised to remain steady, if still elevated — around 7 percent, as of mid-2023.

But what influences mortgage rates in the first place? The Fed? Inflation? Something else? It’s natural to wonder, given how important financing is to homebuyers, and how dramatic rate moves like those of the last year can dash homeownership dreams and budgets.

Truth is, many factors dictate the interest you’ll pay on a home loan, some in your control and some not. “A combination of market conditions and personal financial circumstances influence mortgage rates,” says Andrew Latham, a certified financial planner based in Rolesville, North Carolina.

From financial markets to your financial profile, here’s a quick course on how mortgage rates are determined that’ll help their moves make more sense — and maybe even save you money on a new loan or a refinance.

How are mortgage interest rates determined?

It may seem like mortgage terms are being dictated by a bank or lender: They’re the ones advertising the rates, right? But actually, mortgage rates “are not directly set by any one entity but rather arise from the interplay of complex economic factors,” Latham explains. “Lenders typically set their rates based on the return they need to make a profit after accounting for risks and costs.”

Of course, they don’t just pluck numbers out of the air.  A mortgage loan is essentially debt, and for context, lenders look to another type of debt: bonds. “When investors purchase bonds, they are essentially lending money in exchange for periodic interest payments and a return of the principal when the bond matures,” says Dennis Shirshikov, a strategist for Awning.com and a professor of economics and finance at City University of New York. The annual rate of return a bond offers investors, reflecting its price and its interest rate, is known as its yield. “Mortgage rates are heavily influenced by these [bond] yields,” he explains.

There are many types of bonds, but the ones that lenders focus on are mortgage-backed securities (MBS), whose rates are closely tied to those of U.S. Treasury notes or bonds (T-bonds), particularly the 10-year Treasury. “Mortgage-backed securities usually trade at an interest rate premium to the T-bonds, and this difference between Treasury rates and MBS rates is called the mortgage spread,” says Preetam Purohit, head of hedging and analytics for Embrace Home Loans. “Mortgage lenders usually add a margin to the MBS rate to come up with the rate they charge for a mortgage loan.

“Banks that [originate] mortgage loans, on the other hand, use a different mechanism to set their own mortgage rates because banks can retain loans on their balance sheets. They usually use a cost of funds plus bank margin approach to set their own mortgage rates,” he adds.

Market factors impacting mortgage interest rates

Of course, bonds don’t perform in a vacuum; their “yield is influenced by the state of the economy, inflation, Federal Reserve policy and investor sentiment, among other things,” Shirshikov notes. So these various market elements ultimately affect mortgage rates, too. Among them:

• The economy. What happens in the economy, and how those events affect investors’ confidence, influences mortgage pricing. Good and bad economic news has an inverse impact on the direction of mortgage rates. When the national economy is robust, and job growth high, mortgage rates tend to increase. This is partly due to investors deciding where to put their money; if they find more attractive returns elsewhere, the bond market will need to increase interest rates to compete, which results in costlier rates for borrowers. “Conversely, during economic downturns, mortgage rates tend to decline as money flows from more risky investments to more stable investments like mortgages,” adds Scott Bridges, senior managing director of consumer direct lending for Pennymac.
• Inflation. Inflation, the increase in the pricing of goods and services over time, is an important benchmark when measuring economic growth. Rising inflation limits consumers’ purchasing power, 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 and the returns they demand on mortgages and other bonds they purchase on the secondary market. When inflation is elevated, investors commonly pursue investments that can beat or match its climb. This intensified demand for high yields means less-preferable mortgage rates for consumers.

• The Federal Reserve. The Federal Reserve doesn’t set mortgage rates, but its monetary policy decisions definitely influence them. “The Fed can raise or lower short-term interest rates, which indirectly affects mortgage rates. When the Fed raises rates, it becomes more expensive for banks and lenders to borrow money; this translates to increased rates for borrowers. When the Fed lowers rates, it becomes cheaper to borrow money, resulting in lower mortgage rates,” Bridges explains. For example, as the Fed began hiking interest rates in 2022, in an effort to squelch inflation, mortgage rates rose first in response, and then in anticipation of, the central bank’s moves.
• Financial markets. The performance of T-bonds and mortgage-backed securities plays a role in your mortgage’s interest rate. “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,” says Greg McBride, CFA, Bankrate’s chief financial analyst.  Mortgage rate levels are priced above that of the 10-year Treasury; the spread between them reflects the risk that investors bear for holding those bonds. “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.”
• Government policies. If the federal government produces policies that promote homeownership, such as down payment assistance or tax credits, it can stimulate demand for mortgages and possibly lead to higher rates.
• Global and/or political events. “A financial crisis in another country, for example, could send investors flocking to U.S. bonds as a safe haven, driving down their yields and, in turn, mortgage rates,” says Shirshikov.

Personal factors impacting mortgage interest rates

Your financial and credit status can also play a major role in the mortgage interest rate you qualify for. In particular:

• Credit score.  A higher credit score can earn you a lower mortgage rate. Lenders want to feel confident that you can and will repay your mortgage. Your credit score is perhaps the most crucial criterion in deciding your creditworthiness — that is, how likely you are to default on the loan. The higher your score, the more likely you’ll be quoted a lower mortgage rate. Borrowers with lower credit scores pay higher interest rates and have more-limited loan options. A good FICO credit score is technically any score of 670 or above.
• Loan-to-value (LTV) ratio. The LTV ratio compares the amount of your loan to the price of the property. A lower LTV typically results in a lower mortgage rate. Your down payment will dictate your LTV; the more you put down (a 20 percent down payment equates to an 80 percent LTV), the lower your LTV and the more creditworthy you appear.
• Debt-to-income (DTI) ratio. Your DTI ratio is the sum of all of your monthly debts divided by your gross monthly income, which signifies your financial stability and capacity to manage debt and afford your loan. Generally, the higher your DTI ratio, the riskier you appear (on paper) to a lender — and the higher your interest rate will be. Most conventional loans allow for a DTI of no more than 45 percent, but some lenders will accept ratios as high as 50 percent if the borrower has compensating factors, such as a savings account with a balance equal to six months’ worth of housing expenses. It’s better to aim for a DTI of 36 percent or less for the best rates.
• Loan amount. Often, the more you borrow, the lower your mortgage rate might be — because a higher loan amount provides the lender with a greater net dollar margin, according to Purohit. Better rates for bigger customers, in effect. Of course, you need to have strong financials to prove you can cover a larger loan.
• Closing costs. What and when you pay in closing costs can dictate your rate as well. Case in point: If you opt to not to pay these fees upfront, but roll them into the loan itself, it can increase your mortgage rate.
• Discount points. These optional extra fees are paid upfront to the lender at closing in exchange for a lower mortgage rate.
• Property type. “Occupancy status, such as if this will be your primary home, secondary home or investment property, can also significantly impact the rate. If the home will be your primary residence, the rate may be lower,” Purohit says. “The type of property will also impact the rate. Any property type other than a single-family home – such as a condo, manufactured home, or two- to four-unit dwelling – will generally increase the mortgage rate.”

How much do mortgage rates vary across lenders?

Mortgage interest rates can vary substantially from lender to lender. This is due to differences in their pricing strategies, cost structures, margins and risk appetites.

“Some lenders may specialize in certain types of borrowers and loans, which influences their pricing. Moreover, lender fees and costs like discount points – which is prepaid interest a borrower can purchase to lower their mortgage rate – can also alter your rate,” Latham says.

The cost of originating mortgages includes tasks such as running a credit check, underwriting, a title search and the many other steps a lender must take to process a loan. “In setting prices, lenders have to look at the cost of origination and decide what margins they want above those costs,” says Jerry Selitto, president of Better.com, an online mortgage lender. “The more efficient a manufacturer of mortgages can be, the more competitive they are on pricing.”

Competition in the local market can make a difference here, too. “An area with higher competition between lenders leads to compressed margins and lower mortgage rates,” Purohit notes.

How different mortgage loan types can have different interest rates

In addition, different types of mortgage products have different rates.

“This is due to variations in term length, risk and market demand,” Latham points out. “For instance, fixed-rate mortgages often charge a higher interest rate than adjustable-rate mortgages during the ARM’s fixed-rate period because lenders of fixed-rate loans bear the risk of interest rate changes during the loan’s term.”

However, once the ARM rate adjusts – often after the first one to five years – the rate can fluctuate up or down, possibly rising substantially.

“Also, government-backed loans like FHA, VA and USDA mortgage loans often charge lower rates because the government guarantees these loans, which reduces the risk for the lender offering the loan,” adds Latham.

The bottom line on what drives mortgages

“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.  “Inflation, inflation, inflation – that’s really the hub on the wheel.”

Knowing more about what drives mortgage rates, who controls mortgage rates, and how rates can vary — depending on the lender and loan product — can make you a better-informed borrower. But trying to time the market is generally a bad idea. If buying a house is a right move for you now, don’t stress about trends or economic outlooks. Start shopping around for financing.

Frequently asked questions

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  How to calculate mortgage interest rates

  Many different factors coalesce to determine the mortgage rate you will pay on your loan. These can include dynamics outside your control like Federal Reserve decisions, inflation, the economy, employment growth, financial markets and government policies. Rates are also set based on personal influences such as your credit score, debt-to-income ratio, loan-to-value ratio, loan amount, closing costs, occupancy status, property type and if you decide to pay discount points. Additionally, different types of mortgages will have different interest rates; for instance, you can count on consistent monthly principal and interest payments with a fixed-rate mortgage loan, but the rate on an adjustable-rate loan can fluctuate up or down after its initial fixed-rate phase.
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  How often do mortgage rates fluctuate?

  Mortgage rates can fluctuate daily, based on a variety of factors like changes in the broader financial market, economic indicators and investor sentiment. Mortgage rates are closely tied to the yields on government bonds, in particular the 10-year Treasury note. If you are shopping for a mortgage loan and are concerned that rates will go higher in the months or weeks ahead, it can be smart to lock in a fixed rate now. Or, you might want to choose an adjustable-rate mortgage (ARM) if you expect you won’t remain in your home past the loan’s initial fixed-rate period or you believe that mortgage rates will drop in the near future (which could provide an opportune time to refinance to a new fixed-rate loan).
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  How to get the best mortgage interest rate

  To improve your chances of being quoted a lower mortgage interest rate, the experts recommend improving your credit score by paying your bills on time, paying off outstanding debt and not opening new credit accounts; shopping around and comparing several lenders and loan products; increasing your down payment; and paying discount points to decrease your mortgage rate.