How Is Your Mortgage Interest Rate Determined?

2009 December 22
by Kyle Bumpus
from → Credit And Debt, Real Estate

There are a number of factors that influence how your mortgage interest rate is determined. For anyone in the market for a mortgage (be it for a new purchase or a mortgage refinance), understanding the basics of how interest rates are set will be a tremendous help in making informed financial decisions.

The Benchmarks

The benchmark many rely on to judge short-run mortgage interest rate fluctuations is the 5- year Treasury bill. When the 5-year bill rate go up, interest rates typically follow suit. Treasuries are backed by the United States government and are commonly considered among the safest investments on the planet, making them a benchmark for other bonds. Mortgages, however, are backed only by the value of the underlying real estate.  Therefore, investors demand a higher interest rate to compensate for the extra risk. If treasury rates go up, mortgage interest rates must go up as well to remain competitive.

In addition to the treasury benchmark, other factors will influence mortgage rates. Supply is one such factor. When loan originations increase dramatically over a short period of time, prices on mortgage-backed securities will tend to become somewhat depressed, so interest rates will have to go up a bit to compensate in classic supply-and-demand fashion. Inflation is also another factor that influences mortgage interest rates. If the market fears future inflation, interest rates will go up. During periods of low inflation (or even deflationary periods, which was a valid fear until recently), rates will typically drop.

The Fed’s Influence

The Federal Reserve also plays a role in determining your mortgage interest rate (thanks Ben!). When the Fed changes the Federal Funds Rate, interest rates on all manner of assets change in response. The general rule is that bad economic news will keep rates low while good news will jack up interest rates.

Personal Factors

Your own financial situation is a factor in the interest rate you will qualify for. Your credit score is used by lenders to determine how much of a credit risk you are (which is why it’s a good idea to get a free copy of your credit report). If your credit score is excellent (check your myFICO® credit score now), you will qualify for a lower rate. Not-so-good scores will likely raise your rates because lenders are taking on more risk by lending to you.

The size of your down payment will also be a factor. The more you put down on a property out of your own pocket, the more you have to lose (and presumably will be more committed to keeping current on your payments). The lender will also have a greater margin of error, since your equity cushion will absorb the brunt of the impact should real estate prices decline (it’s happened before, as we are all now aware).

How to Find the Best Mortgage Interest Rate

The best way to score the lowest rates for a mortgage is to be prepared. Get a copy of your credit report and see where improvements can be made. A higher score means better options. You should also commit to saving up at least 20% of the purchase price of your new home long before you consider pulling the trigger.

While interest rates are important, other factors such as the length or your mortgage term (30 years vs 15 years) and whether the rate is fixed or variable. Make sure you are never rushed into making a decision. Never sign on the dotted line until your questions are answered and you clearly understand the terms of the loan and most importantly of all, take your time. If you are in a hurry to get into a home, you may be more inclined to agree to poor terms.

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One Response
  1. 2009 December 25

    Isn’t it funny how for a buyer you really want the economy to be doing bad so you can get a great rate? Still, a person’s own credit has to be in good shape to take advantage of good rates.

    Thanks for listing out the factors!

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