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What Determines Your Mortgage Rate?

how are mortgage rates determined

No single element determines the mortgage rate you receive. A combination of factors — some of which you can influence and others you cannot — affect the interest rate.

For example, if you have a good credit score or choose a shorter-term loan you can probably get a lower mortgage rate. Meanwhile, economic trends like inflation are out of your hands.

Even so, knowledge is power: Learning how mortgage rates are determined can help you find the best possible deal. Saving even a fraction of a percent on your mortgage interest rate can translate to thousands of dollars saved during the life of the loan.

Factors that ARE in your control:

Your credit score

Maintaining a good credit score can make a big difference, since it shows mortgage lenders that you’re responsible about paying your bills. Generally speaking, people with higher scores get lower rates.  

Here’s one example of how that might play out, from the May 2018 Lending Tree Mortgage Offers Report:

  • Homebuyers with credit scores of 760 and higher were offered annual percentage rates of 4.89%
  • Homebuyers with scores of 680 to 719 were offered APRs of 5.17%
  • Based on an average purchase loan of $236,697, the second group of borrowers would pay almost $15,000 more over the life of a 30-year mortgage. That difference is due at least in part to higher interest rates.

Location, location, location

Where you buy makes a difference, since mortgage rates vary from state to state. Some areas are so expensive that potential buyers need “jumbo” mortgages, those with amounts higher than the limits set by Fannie Mae and Freddie Mac; such mortgages usually have interest rates that are 0.25% to 0.50% higher. If you’re bound in a pricey region, you’ll probably wind up paying more.

However, interest rates in rural areas may also be high because lenders aren’t as accustomed to working with those regions. Be sure to check with regional banks and credit unions along with other lenders.

The U.S. Department of Agriculture offers a mortgage program for rural areas, with interest rates generally lower than other government-backed loans. As of February 2018, this loan had a baseline rate of 3.25%; some borrowers qualify for subsidies that can drop the interest rate to as low as 1%.  

Loan amount

Again, if you’re buying in an expensive region, you might not have many choices. For example, if your new job is in Silicon Valley, it can be hard to find an affordable home. Mortgages that are particularly large can carry higher interest rates.

Those looking to live in less-pricey places have more options. It could be that Suburb A and Suburb B have the same kind of housing stock and neighborhood amenities, yet starter homes in Suburb B cost $10,000 less.

Planning to put a big down payment on a fixer-upper in a dirt-cheap area? Be aware that mortgages of $50,000 or less also carry higher interest rates. That’s because they aren’t as profitable for lenders; in fact, some lenders refuse to write small mortgages.  

Down payment

Generally speaking, the more you put down the lower your mortgage rate will be. That’s because a large upfront payment reduces the lender’s risk.

A down payment of 20% (or more) means other benefits, too:

  • Lower closing costs, since some of those fees are based on the loan total  
  • No need for private mortgage insurance
  • A smaller monthly payment
  • Flexibility: If for any reason you need to sell, having some equity in the home means you could sell at a discount if you had to, without having to put more cash into the transaction

If you can put down at least 20% without busting your budget, do it.

Length of mortgage term

Generally speaking, a 15-year mortgage will have a lower interest rate (but higher monthly payments) than a 30-year home loan. As of June 14, 2018, Freddie Mac listed the 15-year fixed-rate mortgage average interest rate as 4.07%, while the 30-year fixed-rate average rate was 4.62%.

Being in a position to take the shorter-term mortgage — for example, being willing to make certain personal sacrifices to pay the loan off faster — means you’ll pay less in interest than you would with a longer mortgage.

Type of mortgage

Conforming mortgages are those that can be purchased by Freddie Mac or Fannie Mae. They usually have the lowest interest rates. However, a conforming mortgage requires at least 5% down and good credit, and if you can’t put 20% down, you’ll have to buy private mortgage insurance.

Conventional or nonconforming mortgages, which cannot be sold to Freddie Mac or Fannie Mae, aren’t provided by every lender. (Jumbo mortgages and many condominium mortgages are conventional loans.) If you go this route, look for a conventional mortgage interest rate that’s competitive with conforming loan rates.

Federal Housing Authority mortgages are designed for those with less than stellar credit and/or low down payments. These loans are backed by the U.S. government but issued through FHA-approved lenders, which keeps interest rates reasonable. Homebuyers who are well-qualified should look elsewhere, since FHA mortgages require annual mortgage insurance for the life of the loan. As of April 2018, the rate for a 30-year FHA loan was 4.84%.

Veterans Affairs mortgages are, as the name suggests, available to veterans. Generally there’s an upfront loan fee, but VA mortgages require neither down payments nor private mortgage insurance, among other benefits. They also tend to carry a lower interest rate: In the past four years, interest on a 30-year VA loan has been 0.25% to 0.42% lower than conventional and FHA mortgages.
 
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Factors that are NOT in your control:

Bond yields

The 10-year Treasury bond is a main indicator for U.S. home loan interest rates. That’s because most mortgages get sold into the mortgage bond market, where they’re turned into pools of loans known as mortgage-backed securities (MBS).

When the yield on 10-year Treasury notes is high, it’s an indication that people are less interested in safe investments like bonds, which can correlate to higher mortgage rates. When the yield is low and lots of folks are buying up bonds, rates tend to increase.

The Federal Reserve Bank’s monetary policy

Normally, the Federal Reserve adjusts the nation’s finances by altering the federal funds rate (the short-term loan rate banks charge each other). In turn, these adjustments affect short-term interest rates for consumers on products like checking accounts, savings accounts and credit card APRs.

Just because the Fed raises rates — as they have been doing steadily over the last year — it does not necessarily mean mortgage rates will follow.  In fact, the idea that the Fed funds rate is directly tied to the fate of mortgage rates is a misconception, Kapfidze explained.

That being said, the Fed can have a direct impact on mortgage rates in other ways:

The Federal Reserve influences mortgage interest rates by changing what it holds on its balance sheet. Right now, the Federal Reserve has trillions of dollars in assets. About half of its assets are held in U.S. Treasury securities while about 40% consists of mortgage-backed securities.

By buying and selling these assets, the Federal Reserve influences how mortgage lenders set interest rates, according to Kapfidze.

Following the financial crisis in 2008, the Federal Reserve bought trillions of dollars of Treasury securities and mortgage-backed securities, which drove interest rates on mortgages down significantly. Today, the Federal Reserve is selling off assets or allowing the assets to mature. If you remember what we said about the relationship between bond yield and mortgage rates in the previous section, you’ll see that this is the Fed’s way of sending mortgage rates higher.

Inflation

Inflation can boost the 10-year Treasury note yield as there is an inflation expectation component to the rate. And when Treasury bonds go up, mortgage rates tend to follow. This is how inflation could boost mortgage rates, Kapfidze said.

Learn more: Will your interest rate change?

Of major concern is the type of interest rate: fixed or adjustable. A fixed-interest mortgage has a rate that does not change during the term of the loan. The static nature of the monthly payment lets you budget accordingly, with no surprises.

An adjustable-rate mortgage (ARM) might be “fixed” initially — sometimes at extremely low interests — but will change after a certain period agreed upon in the loan document. Once the interest rate resets, the loan may become unaffordable (especially if you’ve experienced a loss of income or some other financial problem). For that reason, these loans are considered riskier than fixed loans.

What about points?

Points, also known as “discount points,” can lower your mortgage interest rate. Each point costs 1% of the mortgage loan amount.

Is it worth it? Divide the cost of the point by the difference from the former and new monthly payments; the result is the number of months it will take for the upfront money to pay for itself.

If you plan to stay in the home for significantly longer than that time period, it can make sense to buy points. If not, pass.  

How to get personalized mortgage rate offers  

Would you take the first price offered by a car salesperson? Probably not. Then why take the first published mortgage rate you see?

According to the U.S. Consumer Financial Protection Bureau, only 53% of U.S. homebuyers take the time to compare lenders. Using an online comparison tool like the one offered by LendingTree gives you a clearer picture of your options.

Suppose the company you want to use doesn’t have quite as good a deal as the one across town? Take the better offer to your preferred lender and ask for a match. It could happen — and if so, you’ll be saving thousands of dollars.

The bottom line

A home is one of the biggest purchases most people will ever make. Mortgage loans shouldn’t be entered into lightly.

Weigh the pros and cons of different loan types (conventional versus FHA, fixed-rate versus adjustable). Contact multiple lenders for the best mortgage interest rates, and be ready to negotiate to get the deal you want with the lender you prefer.

If you’re not quite ready to buy, start making financial life choices that will favorably influence the interest rate you receive. For example, the more money you save the bigger the down payment you can make, and a good credit score makes a big difference to lenders.

Be an informed consumer and approach homebuying with the same due diligence you use for buying things like smartphones or automobiles. Getting the best possible mortgage rate can save you a great deal of money over the life of the loan.

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