How Mortgage Rates are Determined

There are many variables that will determine current mortgage rates.  When assessing the direction of mortgage rates and the underlying factors that determine mortgage rates, there are two main forces that help shape the interest rates.  The first factor involves macroeconomic forces that impact mortgage rates and interest rates and the second is the factors that are impacting a specific mortgage loan request.

Macro economic factors that affect mortgage rates include the inflation rate, economic activity and actions by the Federal Reserve.  The rate of inflation is generally one the biggest components of the overall level of interest rates.  A modest rate or low level of inflation will almost always lead to low interest rates, while concerns about rising inflation normally cause interest rates and consequently mortgage rates to increase.

Economic activity contributes to the direction of interest rates with brisk activity tending to drive interest rates higher while lower economic production tends to pull rates down.  The affect of economic activity is a result of the demand for loans.  As loan demand increases with increased economic activity, the interest rates on loans including mortgage loans increases.

The Federal Reserve’s actions have a significant impact on short term bank rates which in turn applies pressure to all rates including longer term rates and mortgage rates over time.  The Federal Reserve, implements policies and generally announces its policies which are designed to keep inflation and interest rates relatively low and stable but a number of market forces can force the Federal Reserve to raise short term rates and thus push long term rates higher as well.

Loan specific factors that influence mortgage rates include: the type of home loan, the borrower’s qualifications, the property, the fees and points paid and the mortgage rate lock period.

The type of home loan impacts the mortgage rate because some types of properties have different mortgage rates than others primarily because of historical risk analysis.  Condominiums have historically had higher default rates than single family homes especially during market slowdowns and therefore are frequently priced slightly higher than single family detached homes.  Multi unit properties may have higher mortgage rates for similar reasons over the risk of default and non owner occupied properties will almost always have a higher mortgage rate due to the increased risk seen by the mortgage lender.

The borrower’s profile affects the mortgage rate based on their inherent risk factors regarding their credit history and financial position.  The risk factors are determined by the mortgage lenders and are generally based on quantitative figures such as the credit profile or credit score of the borrower, the down payment amount and the debt ratios of the borrower. 

Clearly, a borrower with a poor credit score will have a higher mortgage rate than one with an excellent credit score due to the higher risk of default on the loan. 

Similarly, a mortgage loan that was obtained with a larger down payment than one with the minimum down payment will have a lower default risk and generally receives a slightly lower mortgage rate.  This is why borrowers will often seen an advertised mortgage rate and then when they apply for the loan find the rate higher if they are placing the minimum down payment to obtain the mortgage loan.  Lower down payments are the equivalent to higher loan to values and higher loan to values are seen as a greater risk and will have a higher mortgage rate.

The following items will reduce risk or perceived risk to the mortgage lender and generally lead to a lower mortgage rate: higher credit score, greater equity in the house or a larger down payment, a low debt to income ratio or a better ability to pay with a low debt to income ratio.

Increased points and fees generally lead to a lower mortgage rate while lower points and fees lead to a higher mortgage rate.  Mortgage rates and points or total closing costs are often a trade off.  A point is equal to 1% of the loan amount.  A mortgage loan for $150,000 with a rate of 5.50% and 1 point will have a minimum cost of $1,500.00 or 1% of $150,000.00, in addition to the other closing costs charged by the mortgage lender.  In a case such as this, the potential borrower may have the option to pay more points, perhaps 2 points instead of 1, and have the mortgage rate reduced for the additional charge. 

There may also be the option to obtain the mortgage loan without points with a slightly higher interest rate.  The trade off comes down to the cost of points which are paid at the time of the loan closing versus the mortgage rate which impacts the monthly mortgage payment for the life of the loan.

The mortgage rate lock period or time frame will also impact the mortgage rate.  This is the smallest of the factors that will impact the rate but it is important to understand the concept and mechanism of rate locks.  The rate lock period is the length of time that the mortgage rate offered by the mortgage lender is good for.  Home loan borrowers can choose to lock in a mortgage rate for a period of time that generally runs between 30 days to 90 days but can also be obtained for as long as 180 days. 

Without a mortgage rate lock, the mortgage rate is floating or will change as the market changes.  When a potential borrower calls a mortgage lender for a rate quote, some mortgage lenders quote short term rate locks since they offer the best rate.  A short term rate lock is of little use if the mortgage loan is not going to close or fund within the rate lock time period. 

If a mortgage loan request does not close and fund before the lock expires, then the borrower will end up with a mortgage rate that will be at the mercy of whatever changes may have taken place in the market.  The longer the lock in period, the more expensive it is to lock.  Borrowers can also choose to float their rate initially, and lock in for a shorter period of time once they are near closing date.  Floating the rate may save a little money, but it is also has the risk of being stick in a rising rate environment. 

In a volatile market, a mortgage shopper may call about mortgage rates at one time during the day only to find out the rate has changed later in the day when they decide on the best mortgage lender to work with.  Without the mortgage loan application and the rate lock agreement, the mortgage shopper will end up with the prevailing mortgage rate at the time the application and/or rate lock agreement is executed.

Mortgage rates change by small amounts between 30 and 60 day locks, the 90 day locks and 180 day lock periods will often bring about a measurable higher rate and may even entail and upfront fee for the rate lock.  Most long term locks are used for new construction where the time from loan application to loan closing may run for several months.