What affects mortgage rates?

The rising in interest rates that began when COVID-19 fears subsided have homebuyers and sellers on edge, but historically rates are still average. Mortgage rates change daily based on many factors, some of which you can control but many of which you can't control. For example, raising your credit score can help you get a lower interest rate, but you can't do much if millions of other people are looking for houses at the same time and driving rates up.

To understand how you can get a better rate, you should try to understand how mortgage interest rates are determined in general - and what causes them to rise and fall over time.

How are mortgage rates determined?

Individual mortgage lenders set their own rates and there is no single source that sets mortgage interest rates for the whole country. The rates that a lender offers you also depend on multiple factors, so if you went to two banks that are across the street from each other, it's possible they would each offer you different rates.

Lenders consider many factors, but we can give you a high-level breakdown of the process to determine mortgage rates:

1. ‍Start with the Federal funds rate, which is set by the Federal Reserve.
2. Add to the federal rate to find the prime rate — generally done by the nation's largest financial institutions.‍
3. Set Individual rates, which each lender does based on economic factors and adjusted according to each customer's financial situation.

At the most basic level, mortgage rates start with the effective federal funds rate. This federal funds rate is set by the Federal Reserve Bank and is the interest rate that banks and other institutions pay when they want to borrow money from each other.

The largest financial institutions will take this federal lending rate and add an additional amount to it, like to account for expenses they experience when lending to their own customers, and this brings them to the prime rate. Keep in mind that the prime rate isn't the best available rate — it's more like an average rate. A common source for the U.S. prime rate is the Wall Street Journal, which defines the prime rate as "the base rate on corporate loans posted by at least 70% of the 10 largest U.S. banks."

The prime rate serves as the benchmark for all other lenders, which set their own rates based on various economic conditions, like your local economy, and based on a customer's personal situation, like their credit score and income level.

What factors affect mortgage rates?

A lender considers many factors when setting their mortgage interest rates, some of which you can control, like your credit score and your personal financial situation. But you can't control most mortgage rate factors, such as how the overall economy is doing, the state of the job market, worker incomes, supply and demand for new houses, and actions by the federal government.

4 mortgage rate factors you can control

There are only a handful of mortgage rate factors in your control, but knowing what they are can help you get a lower interest rate. Here are some personal factors a lender will consider:

• Credit score
• Income-to-debt ratio 
• Down payment amount
• Loan-to-value ratio

Boost your credit score

People with higher credit scores are seen as more likely to pay back their debts on time, and people with higher credit scores usually get lower mortgage rates. (This is true not just for mortgages, but other loans, too.) Most lenders use your FICO score, which ranges from 300 to 850. Lenders offer mortgage rates according to credit score levels, and having a score close to or above 800 is usually enough to qualify you for the best level of interest rates. (A perfect score of 850 is rare and not worth chasing — less than 2% of the population having a perfect score.) 

→ Bad credit? Find out your options when buying a home.

Lower your debt-to-income ratio

Debt-to-income (DTI) ratios are very important to lenders because they give lenders an idea how likely you are to pay back a mortgage. Your DTI ratio is your total debt compared to your income. Higher ratios mean that more of your income has to go toward paying off debt, and people with higher DTI ratios get higher rates from lenders because the lenders may have a harder time paying back new mortgage debt. You probably need a DTI ratio of 43% or less to get a decent mortgage rate, though some lenders prefer a ratio below 36%. The only ways to improve your DTI ratio are to pay off your debts or increase your income.

To calculate your debt-to-income ratio, divide your total monthly debts by your gross monthly income (before taxes, insurance, and retirement accounts). Multiply your result by 100 to get a percentage. As an example, a DTI ratio of 0.383 or 38.3% means your debts are worth 38.3% of your income.

Make the biggest down payment possible

Making a bigger down payment means you have a small mortgage to pay off, and most lenders prefer to lend to someone with less debt.

Try to make the largest down payment possible. (A 20% down payment isn't necessary even though that's the traditional rule.) Paying more up front will probably get you a lower monthly payment and decrease any private mortgage insurance (PMI) you need to pay.

You might also consider buying down the rate at closing.

Loan-to-value ratio

You may also hear people discuss your loan-to-value ratio, which is your mortgage loan amount versus the remaining value of the house. If you make a down payment of 5%, your LTV ratio is 95% because 95% of the home's value remains unpaid. Lenders prefer lower people with lower LTV ratios, meaning people who can make higher down payments.

→ Learn how to calculate your LTV

5 mortgage rate factors you can't control

Unfortunately, there are many economic factors that influence mortgage rates but that you can't control:

• The general economy
• Supply and demand for homes
• 10-year U.S. Treasury Note and mortgage-backed securities (MBSs)
• Inflation
• Federal Reserve decisions

How the economy affects mortgage rates

Mortgage rates are generally higher when the economy is doing well, because people have more money to spend and higher demand drives up rates when there are only so many houses available. 

Rates generally go down during economic downturns because people may have less money to spend on a major purchase. Banks and lenders may also become stricter with their lending requirements during economic downturns. Other economic factors, like inflation, rising or falling incomes, and employment rates can also affect mortgage rates.

Related: Should you buy a house during a recession?

Real estate supply and demand

When housing stock (the number of available houses) is low, prices usually rise because more people are bidding on a smaller number of houses. When the demand for houses is low but the number of available houses is high, home prices usually fall because sellers will have a harder time getting people to buy.

→ Find out if and when house prices will go down

The 10-year Treasury Note and mortgage-backed securities

The yield on the 10-year U.S. Treasury note typically moves in the same direction as mortgage rates so it's traditionally seen as a benchmark for mortgage rates. What does that actually mean and why does it happen? It's a bit complicated, but it all comes down to investors reacting to the bond market and mortgage-back securities (MBSs).

The 10-year Treasury note is a kind of bond that offers relatively safe, long-term returns. Investors buy more of this "safe" investment when the economy is doing poorly or looks like it will decline in the near future. A very important feature of bonds is that when more people buy bonds, the price to buy them (bond rates) goes up but the bond yield (the value of their payouts) go down. When fewer people buy bonds, rates go down but yields increase.

Meanwhile, banks are trying to sell mortgage-backed securities — bundles of residential mortgages the bank has issued — but these MBSs are considered riskier investments than bonds. To keep investors buying MBSs when bond prices are down, MBS prices also go down. Similar to bonds, when the price to invest in MBSs goes down, banks compensate by increasing the values of the mortgages (the rates people pay the lender to get individual loans). So if investor demand for MBSs is low, mortgage rates will go higher; when demand for MBSs is high, the rates will decrease.

In the end, periods of lower bond yields (payout values), especially the 10-year U.S. Treasury note, often coincide with banks getting lower payouts for their mortgage-backed securities and thus needing to increase mortgage interest rates to make up the difference. To be clear, bonds and MBSs are independent of each other, but many analysts take for granted that they move in tandem and treat changes for the 10-year Treasury note as an indicator of mortgage rate changes.

Inflation

Home prices are not exempt from the effects of inflation, and prices may rise higher or more quickly in some places and not others. Ultimately, supply and demand have a big impact on inflation, with times of high demand and low housing stock driving up prices on the available homes.

Changes in inflation could also spur actions from the Federal Reserve, which make policy decisions to stimulate or slow the economy accordingly.

The Federal Reserve

The Fed's monetary policy can have a big effect on interest rates because they set the federal fund rate (also referred to as the policy rate), which can indirectly affect demand for housing.

For example, the Fed typically raises rates to slow the economy and curb inflation. Increasing the Fed rate makes it more expensive for banks to borrow money, which in turn increases the rates they extend to their own borrowers. That means mortgage rates (as well as credit card and savings rate) will go up, and when rates are high, then the demand for housing will go down, resulting in less competition for houses — one reason it could still be a good time to buy a home now.

The Fed also takes other actions that impact the economy and housing market. For example, the Fed may decide at some points to buy more mortgage-back securities to support the financial institutions selling those MBSs, likely meaning lower mortgage rates for borrowers and potential homebuyers.

Mortgage rates FAQs

There are a lot of factors that affect mortgage rates. Here are answers to some of the most commonly asked questions about this complex topic:

What would make mortgage rates go down?

Mortgage rates are expected to soften when inflation cools and the Federal Reserve stops raising interest rates. However, they are unlikely to return to the historic lows of 2% to 3% during the pandemic.

How do I get the best mortgage interest rate?

You can improve your interest rate by taking steps to make yourself a more appealing borrower to lenders. Improve your credit score, research and compare rates among different lenders, opt for a shorter loan term if possible, and make a larger down payment. And when you find a good rate, make sure to lock it in, as rates can fluctuate throughout the homebuying process.

How much do mortgage rates vary across lenders?

Mortgage rates can vary significantly across lenders because lenders assess risk differently and have different business models, all of which impacts the rates they provide. Shopping around and considering various lenders could potentially save you a substantial amount over the life of your loan.

How much do mortgage rates vary across mortgage types?

Mortgage rates vary significantly across different mortgage types. Fixed-rate mortgages offer stable interest rates over the loan term. Adjustable-rate mortgages (ARMs) have lower initial rates with the potential to fluctuate to higher rates over the lifetime of the loan. Government-backed loans, such as FHA or VA loans, often have the most competitive rates and more lenient qualification requirements. Jumbo loans, designed for higher loan amounts, can have slightly higher rates due to the increased risk they pose to lenders.