Understanding what determines mortgage rates: A guide

Mortgage interest rates fluctuate over time, sometimes dramatically. During the pandemic, the average rate for 30-year fixed mortgages dropped as low as 2.67%. Just a few years later, it soared to the mid 7% range. But why exactly do these rates change so drastically?

In this article, you’ll discover what determines mortgage rates at the economic, lender, and borrower levels so you can budget effectively and select the best option.

What are mortgage rates?

Mortgage rates determine how much interest you’ll pay over the life of your loan and directly affect your monthly payment. Early on, most of your installments go toward interest with a smaller portion applied to principal. Over time, more applies to principal, gradually reducing your loan balance.

Different mortgage types handle interest in distinct ways. Fixed-rate loans, for example, keep your rate the same for the entire term, giving borrowers predictable payments. On the other hand, adjustable-rate mortgages change based on market conditions, which can cause your monthly payment to rise and fall. Some loans start with a fixed rate for an initial period, then convert to an adjustable rate.

You can also refinance to secure a lower interest rate or switch to a loan type that better fits your financial goals. Knowing your options helps you plan payments and stay in control of your budget.

How is a mortgage rate determined? Economic factors

Here are some of the key economic influences that determine mortgage rates right now.

10-year Treasury yields

A 10-year Treasury note is a long-term bond. The government pays investors interest twice a year and returns the full amount when the bond matures.

Investors watch these yields closely because they serve as a benchmark for long-term borrowing costs, including mortgage rates. When Treasury yields rise, lenders often increase mortgage rates to maintain their profit margins. When yields fall, rates tend to drop as well. Global events and economic conditions can influence the demand for Treasuries, which in turn affects the rates borrowers pay.

If you want to get a sense for how the mortgage interest rate might change in the near future, watching the 10-year Treasury market can give you an idea of where rates are headed.

Monetary policy

The Federal Reserve, the central bank of the United States, uses several tools to influence the economy. Its most impactful tool is the federal funds rate — what banks charge each other for overnight loans. 

When this rate goes up, banks face higher borrowing costs. In turn, they pass these expenses on to consumers through higher interest rates on personal loans, credit cards, and mortgages. If the Feds lower the rate, banks’ costs drop, allowing them to offer lower interest rates.

Inflation

Inflation measures how quickly prices for goods and services rise over time, reducing consumers’ purchasing power. As inflation climbs, lenders hike mortgage rates to protect against the declining value of money. When inflation dips, the risk to lenders’ return also drops, allowing them to lower mortgage rates. 

Economic growth

In a strong economy, consumers are more optimistic about their income and job stability. This makes them more willing to take on substantial debt, including mortgages. Higher demand for home loans allows lenders to raise mortgage rates, while slower economic growth can reduce demand and push rates lower.

Investor demand

Mortgage-backed securities (MBS) are bundles of individual home loans sold to investors as investment products. When investors buy these MBS, lenders get more capital to issue new mortgages, which often allows them to offer lower interest rates. 

On the other hand, if investor demand for MBS falls, lenders have less funding available. To maintain returns and attract buyers, they may raise mortgage rates, making borrowing more expensive for homebuyers.

What affects mortgage rates on the lender’s side?

Each lender sets rates based on internal guidelines and preferences. Key factors include:

— Competition: The higher the competition among lenders in the area, the more pressure there is to reduce interest rates to attract borrowers.

— Risk tolerance: Lenders vary in their comfort with risk. Those with low risk tolerance focus on borrowers with strong credit and financial profiles, while lenders willing to take on riskier clients charge a higher rate to compensate.

— Efficiency: Lenders who reduce staffing, paperwork, and processing delays can pass savings to borrowers through lower rates and a smoother mortgage experience.

What factors determine interest rates on the borrower’s side?

We’ve seen how economic factors shape interest rates, but here’s what mortgage rates are based on when it comes to your personal credit profile.

Credit score

Borrowers with higher scores have demonstrated they can manage debt and meet obligations, so lenders see them as safer bets. Lower scores indicate past missed payments, high debt, and other risk signals, which make lenders more cautious and prompt them to charge higher mortgage rates.

Loan-to-value (LTV) ratio

This metric compares the size of your mortgage to the appraised value of your home. A lower LTV means you made a larger down payment than the minimum required. This reduces the lender’s risk because there’s more equity in the home and a smaller loan relative to the property value. This situation allows them to offer a better interest rate. Conversely, a higher LTV increases risk because there’s less equity in the home. This means a smaller buffer if the borrower defaults. To compensate, lenders may charge higher mortgage rates.

Property type

The type of property you’re buying affects your mortgage rate because lenders consider some homes riskier than others. Vacation homes and investment properties, for example, typically carry higher interest rates because of increased risk of default. Essentially, lenders assume borrowers may be less financially committed to these properties or that rental income from investment properties could fluctuate. 

By contrast, primary residences generally qualify for lower rates since lenders view them as lower-risk. Understanding how property type influences rates can help you plan your home purchase and budget more effectively.

Credits

Some lenders offer credits that lower your closing costs in return for slightly higher interest rates. For example, a borrower might accept a 0.25% higher rate to receive $2,000 toward closing expenses. Using these credits makes up-front costs more manageable, though it will slightly increase your monthly payment over time.

Loan term

The length of your mortgage influences your interest rate. A shorter loan, like 15 years, tends to come with lower interest rates because lenders get their money back faster and face less risk. Longer-term loans carry higher rates since the extended repayment period increases the chance of default.

Debt-to-income (DTI) ratio

Your DTI measures what portion of your income goes toward paying off your debts. When it’s on the lower end, this signals to lenders that you’re cautious with your borrowing and less likely to default on a mortgage loan. A high DTI means a lot of your income is tied up in other expenses, so you may experience difficulties paying on time. 

Better helps buyers explore mortgage options with competitive rates and a smooth, hassle-free application process.

Points

Some lenders let you purchase points to lower your interest rates. Each point typically costs 1% of the loan and can reduce your monthly payment over the life of the mortgage. For example, on a $300,000 loan, one point would cost $3,000 and might drop your rate from 5% to 4%. Taking this route can save you money each month if you plan to stay in your home long term, though it increases your initial out-of-pocket costs.

...in as little as 3 minutes – no credit impact

Land a competitive mortgage rate with Better

Factors like inflation, lender requirements, and credit profile influence mortgage rates. Understanding how these rates work helps you set out on your homebuying journey with confidence.

Better simplifies the financing process so you can move forward without stress. Our simple online application process takes as little as three minutes to complete, so you can shop around without slowing down your search. Once you’re ready, funds could be available in as little as a week.

Get started today to see how easy it is to secure a mortgage with great terms through Better.

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FAQ

How do my credit score and down payment affect my rate?

In general, the higher your credit score and down payment, the better rate you can secure because lenders view you as lower risk. Lenders also use metrics like your LTV and DTI ratios to decide what interest rate to offer.

Who sets mortgage rates?

There’s no single governing body that directly decides interest rates for mortgages. A wide variety of factors influence them, including economic conditions, market trends, and lender and borrower decisions.

What factors determine interest rates for mortgages?

Examples of what affect the mortgage interest rate include:

— Economic influences: Monetary policy, inflation, and investor demand for mortgages

— Lender factors: Competition and risk tolerance

— Borrower influences: Credit scores and down payment size