How are Mortgage Interest Rates Determined?

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There’s been a lot of talk about mortgage interest rates over the past few years. Throughout 2020 and 2021, rates dropped to record lows, linked mainly to the economic uncertainty felt worldwide amid a public health crisis.

As the coronavirus became more manageable with vaccines and precautions in place, the economy started to rebound. Now, interest rates have started to rise as financial markets have rallied around that economic recovery.

All of these ups and downs might leave you wondering – what factors really play into how mortgage interest rates are determined? It’s an intertwined combination of market factors, your personal credit profile, and your loan program. We break it all down for you here.

Market Factors That Affect Interest Rates

The biggest contributors to mortgage interest rates are the economy’s overall condition and trends in the financial markets.


How the Bond Market Impacts Rates

You might not be aware, but just like how stocks are traded as a means of investment, mortgages can be too. Investors can trade in home loans through mortgage bonds.

These bonds take shape as collections of loans with similar attributes, including the types of loans, down payment amounts, and borrowers’ credit scores. Investors can then purchase these bonds and earn a rate of return on their investment relative to the risk of that bond.

Investors choose which bonds they’ll buy into based on how much risk they’re comfortable with while also considering how much of a return on their investment they’re seeking.

This affects the interest rate you end up with on your personal home loan because you’ll fall into a particular group of loans, or mortgage bond. And if that group is of higher risk to investors, the interest rate you pay will likely be higher.

Beyond your personal credit profile playing a role here, there’s also the performance of the mortgage bond market compared to overall financial markets playing a role too. As more investors buy mortgage bonds, rates tend to go down, as investors aren’t having to be enticed to purchase them. If money is shifting to stock markets, though, rates usually rise to encourage investment in mortgage bonds.


How the Federal Reserve Can Influence Rates

The Federal Reserve has the task of creating and navigating US financial policy. Part of that responsibility is keeping inflation at bay, ensuring it doesn’t drastically increase or decrease, which creates major economic issues.

One of the tools the Fed uses to regulate inflation is the federal funds rate. This rate dictates how much banks must pay to borrow funds, which in turn impacts the interest rates banks offer to consumers for many types of loans.

At the start of the COVID-19 pandemic, the Fed dropped rates to 0% to help encourage economic activity at a time when consumers were in savings mode.

Today we’re on the other end of the spectrum. To counteract the high rate of inflation we’re currently experiencing, the Fed has raised the federal funds rate, which has contributed to the rise in mortgage interest rates.


Personal Factors That Contribute to Your Interest Rate

Market factors and economic health as a whole play key roles in how we arrive at the mortgage interest rates being offered on any given day. Your personal credit profile is another important component.


Credit Score

Like we already covered, mortgage bonds group like loans together. One of the factors used to group loans together is borrowers’ credit scores.

In general, the higher someone’s credit score indicates a greater length of time they’ve been able to make on-time payments for their debts. From the perspective of a mortgage bond investor, this means less of a risk of default. That equates to a lower cost to borrow the funds for their loan, which results in a lower interest rate.


Down Payment

You might not have thought about it, but putting more money down, or bringing more equity into your refinancing transaction, signals a lower risk to lenders and investors.

That’s because your lender is contributing a lower percentage of the overall property value when they fund your loan. That reduces their risk because your equity stake is higher, and borrowers tend to be less likely to give up that equity stake they’ve paid for.

What that means in savings for you as a borrower is that you can oftentimes secure a lower interest rate if you’re able to put more money down or bring more equity to the table.


Type of Occupancy

You might not know that the type of occupancy of your property can also contribute to your interest rate. It actually does, and it’s, again, related to risk.

Borrowers are more likely to ensure a mortgage on their primary residence is paid on time during an economic hardship because that’s where they live.

If you were to hypothetically find yourself in a difficult financial spot, although it’s a difficult decision, you would likely forego paying for additional properties before you default on your main home. It’s because of that mentality that there’s a higher risk linked to financing on second homes, vacation homes, and rental properties. And with that higher risk comes higher rates compared to those offered on primary residence mortgages.


How the Type of Loan Program Impacts Your Rate

Each loan program comes with its own set of requirements, and that feeds into how likely it is to get investors to purchase mortgage bonds with that type of loan. That’s one way that the loan program you finance with can impact your interest rate.

But even the term of the loan can have an impact, too. If you opt for a 15-year mortgage, for example, investors recoup their funds sooner than a comparable 30-year loan. That shorter term is rewarded by way of lower interest rates.

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Lisa Perry, Senior Loan Officer

"Your Northern VA Mortgage Specialist"


NMLS ID #86548 / 276329


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Comments (3)

Gary & Melynda Wolter, Since 2001, 480-269-1164
ProSmart Realty - Mesa, AZ
Reliable, Premier Personal Service since 2001

Great post Lisa! All of this information is so needed with our current market and with people coming up with their own thoughts and theories.

Jul 28, 2022 09:44 AM
Paddy Deighan MBA JD PhD - Vail, CO
Paddy Deighan J.D. Ph.D

Very concise and thorough. A lot of people do not understand mortgage interest rates

Jul 29, 2022 09:38 PM
Jan Green - Scottsdale, AZ
Value Added Service, 602-620-2699 - Scottsdale, AZ
HomeSmart Elite Group, REALTOR®, EcoBroker, GREEN

Great information for consumers looking for guidance.  So many think the Fed Funds Rate is the home loan rate, not so!   

Aug 03, 2022 01:52 PM