How Are Mortgage Rates Determined?
Mortgage rates are primarily determined by a lender’s review of your credit scores, LTV ratio and DTI ratio, and how the overall economy is doing. However, there are other factors worth paying attention to that can help you get the best mortgage rate for your homebuying or refinancing plans.
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What determines mortgage rates?
Lenders consider two major factors when determining the rate they’ll offer you:
- What the current market rates are
- How likely you are to be able to repay the loan
The first factor — current market rates — is influenced by the performance of the economy, inflation and the monetary policy set by the Federal Reserve. In other words, things out of your control.
However, your financial profile is something you can control — this includes your credit score, loan-to-value (LTV) ratio and even how much total debt you have, which all contribute to the “ability to repay” factor. A high credit score and down payment combined with a low debt-to-income (DTI) ratio increase the odds you’ll repay your loan as agreed, which allows the lender to offer you a lower rate. However the reverse is true — a low credit score and down payment and a high DTI ratio are likely to lead to a higher rate.
Understanding how market factors and your finances affect mortgage rates can help you make the most educated choice if you’re planning to buy or refinance a home.
How do your finances determine mortgage rates?
The mortgage rate you’re offered is determined in large part by the strength or weakness of your financial profile, and is an indication of how likely your lender thinks you are to repay your mortgage. History and data show that a high credit score and a large down payment reduce the risk you’ll have trouble making your mortgage payment, and lenders offer lower rates to less risky borrowers.
Below, in order of importance, are personal finance factors that impact the rate you’re likely to get:
1. Your mortgage credit score
Mortgage lenders are required to scrutinize your credit history, and they rely heavily on your credit score — it provides them with a review of your past and present credit decisions. A high credit score always leads to a lower mortgage rate, while a lower score will result in a higher rate.
How you’ve paid credit accounts in the past is likely to tell them how you’ll handle mortgage credit in the future. You can control how high your credit score is by:
- Paying all your debt on time
- Keeping your revolving (credit card) debt balances low
- Not opening a lot of credit accounts at once
2. Your down payment
Combined with your credit score, your down payment has the second-largest effect on your mortgage rate — this is especially true if you’re taking out a conventional mortgage. However, there is a silver lining in 2023: Borrowers with scores between 620 and 700 and a down payment between 5% and 20% may get a slightly lower rate after the new changes take effect (more on that below).
3. Whether you’ll live in the home as your primary residence
This is known as “occupancy” in mortgage terms, and the best mortgage rates go to borrowers buying a home they intend to live in as their main residence. If you’re buying a second home or a property to earn rental income, investment property mortgage rates are significantly higher.
History has shown that when hard financial times hit, consumers protect the investment in their primary home over rentals or second homes. As a result, your rate may be marked up by 50 to 87.5 basis points to compensate for the extra risk you might bail on a non-primary home. That means if you’re currently being offered a 6% rate for a primary residence, you can expect to pay 6.5% to 6.875% if you finance the home as a vacation home or rental property.
2023 changes that will affect how your mortgage rate is determined
In 2023, Fannie Mae and Freddie Mac — government-sponsored enterprises that buy and sell conventional mortgages — announced they would be revamping their loan pricing grids. Conventional mortgage lenders are required to use these grids when pricing an interest rate offer. Look for the sign throughout this article to keep track of all of the changes taking effect.
Here are some key takeaways from the new adjustments which go into effect on or after May 1, 2023:
You’ll need a higher credit score to get the lowest rate. The credit score benchmark for the best rates will be 780, which is 40 points higher than the prior 740 standard. One major negative: If you have a score between 700 and 779, you’re likely to be offered a slightly higher rate after the pricing changes kick in.
Lower down payments may result in better rates. This may seem counterintuitive, but borrowers putting down 5% or less may end up with a better rate than borrowers making a 5% to 20% down payment. One possible explanation: private mortgage insurance (PMI). The less you put down, the higher the PMI premium, and that insurance only protects the lender if you default.
That doesn’t mean you should make a small down payment; the monthly mortgage insurance expense will typically outweigh the interest rate benefit, and the more you put down, the lower your monthly payment is.
You may pay a higher interest rate for a higher DTI ratio. Lenders divide your total debt by your income to calculate your DTI ratio, and when the new changes take effect Aug. 1, 2023, a DTI ratio over 40% may lead to a higher rate on a conventional loan. Ask your loan officer what your DTI ratio is if you’re getting preapproved for a mortgage — you may need to lower your maximum loan amount or make a bigger down payment to avoid this adjustment.
Other factors that affect how your mortgage rate is determined
Lenders often use an automated pricing system to generate a rate quote for you, which makes it even more important for you to know other factors that might make a quoted rate higher than you expected.
Property type. Lenders usually offer the best rates on single-family homes, as they’re the most common type of home in most areas. You’ll probably see a higher rate for the following property types.
- Condominiums. Condos come with extra risk because you can’t control what happens outside of the walls of your unit. A condominium building may be sued for an injury in a common area or the association dues may be mismanaged, which could make it hard for the lender to sell if you default.
- Manufactured homes. Although building standards are much higher for a modern-day manufactured home, they’re more prone to value decreases and lenders markup that risk accordingly.
- Multifamily home. Buying a multifamily home with two to four units may be a great house hack, allowing you to live in one unit and earn money on the other units. The drawback to lenders is you can’t control the tenants’ actions, which adds risk similar to owning an investment property. Some good news though: Fannie’s and Freddie’s changes have lowered the markup, which may lead to a lower rate on your multifamily mortgage.
- Purpose of your mortgage. Mortgage companies tend to compete the most for purchase business because it adds a “new” loan to their books. Refinance competition can be fierce when rates are low, but when you start tapping equity or adding a second mortgage to the mix, lenders add on costs to cover the risks.
- Cash out refinance. When your home value rises, your home equity — the difference between how much your home is worth and how much you owe — also increases. You can convert a portion of that equity into cash by borrowing more than you owe and pocketing the difference with a cash-out refinance. Unfortunately, you’ll pay a premium on the rate to the lender for tying up the equity with a larger loan balance when the new pricing changes happen.
- Piggyback financing. One way to avoid mortgage insurance if you can’t make a 20% down payment is to add a home equity loan or home equity line of credit (HELOC) to your down payment. This is called “piggyback financing,” because you’re using two loans to finance the home. The smaller home equity loan or HELOC “piggybacks” onto the larger, first mortgage balance. One popular piggyback structure is the 80-10-10 loan: You borrow a first mortgage balance equal to 80% of your home’s price, add a 10% home equity loan or HELOC and make a 10% down payment. Because your first mortgage is at 80%, you don’t need mortgage insurance. The drawback: The new adjustments add a charge for a piggyback loan structure.
How do market factors determine mortgage rates?
Consumers often look at a mortgage in terms of just one loan on their home. But investors look at mortgages as a fixed-income investment — they front a lump sum to you and you pay them interest over time. For example, if you take out a 30-year fixed-rate loan at a rate of 6%, you commit to paying interest to that investor for the loan term.
However, mortgage lenders need money to lend, and the “cost” of that money depends on market factors such as:
In the economic world, inflation is the rate of increase in prices over a specific time period. You may see inflation in the form of higher grocery, gas and house prices. Inflation is bad for mortgage rates, because it often leads to increases in the federal funds rate (the target rate banks use to lend to each other).
Federal Reserve monetary policy
The Federal Reserve is the central bank of the United States, whose primary purpose is to keep the economy stable by setting monetary policy. If inflation rises too fast, goods and services become more expensive for both consumers and businesses.
One strategy the Fed uses to combat inflation is to increase the federal funds rate, on the premise that higher rates will cool off the economy and reduce inflationary pressure. Lenders generally pass those increases onto consumers in the form of higher rates for all types of loans, including mortgages.
Lender pricing models
Mortgage rates can vary from lender to lender based on “pricing models,” which lenders control depending on how many loans they want to originate and how much profit they want to make. A lender with a higher profit margin is likely to offer a higher rate, which they may justify based on a higher level of service.
Other lenders specialize in being “price leaders,” and may offer very low rates to high-credit-score borrowers with a digital loan process. The fact that lenders can adjust their model at any time makes it even more important to shop with at least three to five lenders to find your best rate. And once you choose the loan estimate at a rate that fits your needs, lock it in — otherwise it’s subject to changes with the market.
What is the current mortgage rate?
The mortgage interest rate forecast for May 2023 is for rates to remain in the 6% range. The average-30-year mortgage rate fell from 6.60% on March 16, 2023, to 6.39% as of April 20, 2023, according to the Freddie Mac Primary Mortgage Market Survey (PMMS). Ups and downs in mortgage rates will continue over the coming months as lenders react to economic news with a watchful eye on inflation, said Jacob Channel, LendingTree’s senior economist. Although there’s evidence inflation growth is slowing, Channel said it’s still rising, and another Fed rate hike may be on the horizon.