Some things that determine the mortgage rate you get are specific to your situation: your credit rating, the size of the loan you want, how much you put down, etc. However, the biggest changes in mortgage interest rates over time are determined by economic and market forces. While you cannot control these forces, it is important to understand them because they can impact decisions you make about your mortgage.
3 Major Components of Mortgage Rates
Think of a mortgage rate as a layer cake with three layers. The bigger or smaller any of those layers becomes, the taller or shorter the cake becomes - or in this case, the higher or lower mortgage interest rates go.
Here are the three key layers to interest rates:
- Inflation. Mortgage lenders give you money now that they expect to get back, with interest, in the future. To protect themselves against inflation eroding the value of those future payments, part of the interest rate they charge is an allowance for inflation. The higher lenders expect inflation to be, the bigger that allowance will be. So, during the early 1980s when inflation was running at double digit rates, it pushed 30-year mortgage interest rates into the teens. More recently, inflation slipping below 2 percent has helped mortgage rates drop below 4 percent.
- Default risk. Some borrowers do not pay back their mortgage loans, and lenders have to protect themselves by building an allowance for default rates into the interest they charge. Mortgage default rates have dropped sharply in recent years, which is another factor helping mortgage interest rates stay low. However, if default rates start to rise significantly, expect interest rates to rise as well.
- Marketplace incentives. Basically, this can be thought of as the profit motive for lenders. While there is always a motive to make a profit, conditions including loan demand, competition, and costs of doing business will determine how much extra a lender will try to build into its interest rates after allowing for inflation and default risk.
Why This Matters to You
Of course, you can't control any of the above factors, so why should you care? Well, you can't control the weather, but you want to know the forecast so you can make decisions about what to wear, how early to leave for work, or even whether to go out at all. Similarly, knowing the factors that drive mortgage interest rates can help you make informed decisions about key mortgage questions, such as:
- Is this a good time to buy a house? Understanding the trends that are likely to influence interest rates can help you decide whether to get into the market now, or wait and see whether rates will drop.
- Should I refinance now? Similarly, if you already own a home, knowing what drives interest rates can help you decide when it's time to refinance.
- What kind of mortgage should I get? In a high rate environment, an adjustable rate mortgage might make some sense - if you think inflation and default rates are likely to fall. In contrast, at a time like now, when inflation and default rates are already low, a fixed rate mortgage probably makes sense for most borrowers.
- Am I getting a fair rate? While interest rates will go up and down as a group, the specific mortgage rate you get depends in part on a variety of marketplace factors that vary from one lender to the next. That is why it is important to shop around and compare lenders, to make sure you are getting a competitive rate.
In the face of macro-economic conditions such as inflation, credit conditions, and the supply and demand of capital, it may seem like the big movers behind mortgage rates are completely beyond your control. However, the more you understand how these forces affect mortgage rates, the better decisions you can make about when to take on a mortgage, what type of mortgage to get, and how to get the best deal.