How are mortgage rates set?
Mortgage rates are a crucial component of the U.S. economy. High rates may discourage homebuying, while low rates can spur a boom in the housing market.
But how are these all-important mortgage rates set? It’s a bit of a complex process based on a slew of factors. Our goal is to simplify it for you.
What determines mortgage rates?
- Mortgage bonds
- The economy
- The Federal Reserve
- Industry competition
- Housing market
- Your personal finances
What’s the role of mortgage bonds?
You may be surprised that the bond market plays a role in where mortgage rates stand. That’s in part because mortgage bonds – also called mortgage-backed securities – exist.
These bonds are basically a pool of individual loans whose credit scores and other factors are similar. Freddie Mac and Fannie Mae, along with investment banks and others, sell mortgage bonds after they purchase the mortgages from lenders and bundle them together. These bonds are long-term – usually 15 or 30 years – and the yield comes from the principal and interest homeowners pay monthly.
If investors are hungry for mortgage bonds, their price will rise and their yield will decline, as will mortgage rates. Why? Lenders know they can sell additional mortgages at those rates and, once they’re bundled by an agency, investors will buy them. The Fed has bought hundreds of billions of dollars of mortgage bonds since the pandemic began in 2020 because it wants lower mortgage rates to boost the economy. That’s been a factor in creating the super-hot housing market across the country.
Mortgage bonds are generally seen as safe, though not as safe as the 10-year Treasury. Because of that, the yield on mortgage bonds will always be higher than Treasury bonds, which are often seen as the safest investment possible because they are backed by the U.S. government.
How does the economy affect mortgage rates?
Bad news for the economy is usually good news for borrowers. Once the pandemic hit, the economy tanked and the Fed began buying hundreds of billions of dollars in mortgage-backed securities, mortgage rates dropped to ultra-low levels. This prompted a wave of new borrowers along with record levels of refinancing from existing homeowners. Of course, the opposite is true – a rising economy will also lift mortgage rates, as lenders do not need to keep rates so low to attract borrowers.
Does inflation impact mortgage rates?
Yes. Inflation lessens the purchasing power of consumers and weakens the U.S. dollar. That means the price of mortgage bonds (which are denominated in U.S. dollars) will fall, and their yields (the return that investors realize on that bond) will rise. Lenders will now need to raise their interest rates on mortgages so they can sell them to Freddie Mac and others at that higher yield. At the same time, the long-term outlook for inflation also will affect the direction of mortgage rates.
What about the Fed?
The Federal Open Market Committee (FOMC), which is a unit of the Fed, meets eight times a year to set monetary policy in the United States. These gatherings are the Fed meetings you hear so much about on the news. During these meetings, the board of governors – led by Fed Chair Jerome Powell -- can raise, lower or leave unchanged the federal funds rate. The governors are guided principally by the goals of maximum unemployment and modest inflation.
Specifically, the federal funds rate is what commercial banks use to lend and borrow from each other. The rate impacts the long-term outlook of the bond market, which as you read above is a driver of mortgage rates.
What about competition between lenders?
Always check the rates among 3-4 lenders. Likely they will vary, if only slightly. All lenders have different motivations, and some may be more willing to compete on price than others to increase volume.
How does the state of the housing market affect mortgage rates?
Most people think of this the other way around – how do mortgage rates affect the housing market? – but the housing market can impact mortgage rates. Let’s say the number of homes for sale decline in an area; that means there won’t be as many borrowers looking for mortgages. To lure more business, lenders will likely have to lower their interest rates.
What is it about my background that will influence my mortgage rate?
Your credit score is a big factor. This helps lenders assess the risk of loaning you money. The higher your credit score, the more likely you will be able to procure a lower interest rate.
How are credit scores derived? They are based on your credit history, which includes whether you are paying off your credit cards every month (if you are, you will have a higher score).
Another important factor is the size of your down payment. The larger the down payment, the lower your loan-to-value ratio, which likely means you will receive a lower interest rate. Why? You have more of your own money invested in the property, which means the lender’s risk is lower.
Your choice regarding the length of the mortgage will also be important in determining the rate. If you decide upon a 15-year fixed rate mortgage, for example, rather than a 30-year mortgage, you will most likely pay a lower rate, based on the history of the average rates of those terms. (Of course, there are reasons why 30-year fixed rate mortgages are the most popular, including monthly payments that are more affordable and you have twice as long to pay off the loan.)
For many people, a house will be the biggest investment of their life and the accompanying mortgage their biggest debt. Figuring out how mortgage rates are set – and understanding what factors of those rates are within their control – can help them save a lot of money on interest payments when they eventually procure one.
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