How are mortgage rates determined?

Mortgage rates are constantly in flux. They are subject to change every day and can even fluctuate multiple times per day. More recently, mortgage rates have become more volatile, changing as much as half a percentage point in a single day.

How mortgage rates are determined is dependent upon numerous factors, both personal and market factors.

But how are mortgage rates calculated? Can you negotiate mortgage rates? And how often do mortgage rates change? In this article, we will answer these questions and more. Here is everything you need to know about how mortgage rates are determined.

How are mortgage rates calculated?

Mortgage rates are determined by numerous factors. What determines mortgage rates can be broken down into these two areas:

• Market factors
• Personal factors

Let’s break down each of these factors to learn more about how mortgage rates are calculated.

Market factors

Before accounting for personal factors, market factors have a significant influence on mortgage rates. These market factors are:

Bond market

Mortgage bonds are the particular mechanism for trading home loans among investors. Mortgage bonds—sometimes referred to as mortgage-backed securities (MBS)—are collections of home loans that share similar characteristics, like credit score, down payment, and the loan’s original investor. Investors that choose bonds decide what to purchase based on their desire for a certain rate of return and risk tolerance.

Beyond personal factors, the bond market is usually seen as a safer bet than the stock market. While the stock market may have a higher rate of return, it is subject to considerably more volatility. Mortgage bonds, on the other hand, offer a guaranteed yield. When people purchase mortgage bonds, mortgage rates usually decrease, since the rate on the underlying mortgage bond does not need to be high to appeal to investors.

Federal Reserve

The Federal Reserve’s primary tool for stabilizing the inflation rate is the federal funds rate. This is the rate at which banks borrow money from each other overnight. By doing so, the Fed can better control the money supply. If short-term interest rates are lower, for instance, money is cheaper to borrow. That increases the overall money supply in the market, pushing prices up. If, on the other hand, interest rates are higher, less money is available, and prices decrease.

When the Federal Reserve keeps short-term interest rates low, mortgage interest rates tend to be lower. This was especially evident when the Fed kept interest rates at or near 0% in response to the COVID-19 pandemic, pulling mortgage rates to historic lows.

Overall economy

The Federal Reserve and the bond markets react to the fluctuations in the overall economy. Typically, when times are prosperous, mortgage rates increase. When investors think a downturn is on the horizon, funds get moved back into bonds and mortgage rates decrease.

Inflation is another factor in how mortgage rates are set. If inflation is high, Americans tend to invest in stocks, since the guaranteed rate of return on bonds drops as inflation rises. For instance, if a bond pays you back 5% and the money supply increases at a rate of 3% per year, you will only get an effective 2% return. It should be noted, however, that if you already have a fixed-rate mortgage, your payment will not change based on inflation.

Lastly, unemployment. If unemployment is higher than the Federal Reserve can handle, the Fed lowers interest rates to stimulate borrowing. This may also be used to help grow the workforce.

Personal factors

In addition to market factors, there are many personal factors that impact your mortgage rate. These include your credit score, your down payment, and how you plan to occupy the property. Your long-term goals also affect your interest rate.

Let’s look more closely at the personal factors that determine your mortgage rate:

Credit score

Your credit score is one of the biggest indicators of risk to mortgage lenders. If all else was equal, your credit score—and the length of your credit history—show lenders you are more likely to make payments on time.

While there are three credit bureaus, the credit score that counts is the lowest median score of all clients on the mortgage. For instance, if you had a median score of 640 and your partner had a median score of 620, the 620 score would count.

Down payment

What else does mortgage rate depend on? The down payment. The more money you put towards your down payment, the less money the bank has to loan to you. It also brings down your risk level. And on conventional loans, if your down payment is less than 20%, you will be required to pay mortgage insurance. You can either have borrower-paid mortgage insurance (which includes a monthly fee) or lender-paid mortgage insurance. If you go for lender-paid mortgage insurance, your mortgage rate will be higher.

Occupancy

By occupancy, we mean how you plan to occupy the home. For instance, is it a primary home, a vacation home, or an investment property? You get the lowest mortgage rate on your primary property. Because they are viewed as greater risks, secondary homes or investment properties will have slightly higher mortgage rates.

The reason for this is if you get into trouble financially, you are going to make payments on your primary home before you do on your other properties. You are also more likely to make more payments on your vacation home rather than your rental property, from which you are presumably collecting rent.

Taking cash out

If you convert home equity into cash, you receive a higher rate than if you were purchasing a property or refinancing to lower your interest rate or change your term. The reason is you are taking on a higher balance than you had going into the transaction. That involves more risk for mortgage investors and lenders.

How are mortgage rates set - does the government control them?

No, the government does not control mortgage rates. The Federal Reserve’s impact on traditional mortgage rates is often misunderstood by homebuyers.

The Fed does not set mortgage rates – that's not how mortgage rates are determined. It does, however, determine the federal funds rate. The federal funds rate usually impacts short-term and variable interest rates, but more indirectly.

The federal funds rate is the rate at which financial institutions such as banks lend money to one another overnight, in order to meet mandated reserve levels. It is costlier for banks to borrow from other banks when the federal funds rate increases. These higher costs can be passed on to consumers in the form of high interest rates. On some extent mortgages, as well as lines of credit and auto loans.

Traditional mortgage rates are impacted by a number of factors. These factors may include Federal Reserve monetary policy including the federal funds rate, and the buying and selling of government securities like bonds.

Can I negotiate the mortgage rate?

Yes. You can negotiate your mortgage rate with mortgage lenders and banks. You can also negotiate other fees, if you are willing to haggle and know which fees to focus on. While many buyers begin their home-buying journey negotiating home prices, few spend as much time negotiating their mortgage.

If, after shopping around, the lender you choose does not offer the lowest mortgage rate, that is when you can start negotiating. How? One approach is to show your lender a copy of a competitor’s offer and ask them to offer a better rate, or match it, at least. Some lenders are willing to lower their mortgage rate to get your business.

What causes mortgage rates to drop?

Some of the biggest driving forces that determine mortgage rates are market factors. The overall health of the economy, the Federal Reserve, and the bond market are just some of the factors that impact mortgage rates.

However, inflation and mortgage rates go together. When inflation rises, interest rates rise. Why? So that they can keep up with the value of the US dollar. If inflation drops, then mortgage rates drop. During periods of low inflation, mortgage rates usually remain at the same level or fluctuate slightly.

One of the main functions of the Federal Reserve is to keep inflation in check. This is why there is confusion around whether the Fed sets mortgage rates. While the Fed does not set mortgage rates, it does influence rates. The Federal Reserve controls short-term interest rates by increasing or decreasing them. When the Fed rate changes, the prime rate for mortgages often follows suit.

How often do mortgage rates change?

Mortgage rates change often. In fact, mortgage rates are in constant flux and can change every day. On some days, mortgage rates can change multiple times. While these changes can be relatively minor, there are times—especially recently—when mortgage rates have been far more volatile. How volatile? Mortgage rates have been known to fluctuate as much as a half percentage point in a single day.

How mortgage rates are set is based on numerous factors. Some of these factors are personal factors, i.e., within your control. Others are market factors that can be influenced by the wider economy and the Federal Reserve.

Understanding how current mortgage rates are determined is an important first step. Next, understand that you have negotiating power, not only when shopping for a house but also when securing a mortgage rate. Remember: the more knowledge you have, the better off you will be. 

If you need help understanding how mortgage rates are determined, get in touch with one of the mortgage professionals we highlight in our Best of Mortgage section. Here you will find the top performing mortgage professionals, including mortgage loan officers, across the USA.

Have experience negotiating your mortgage rate? Let us know in the comment section below.