How Are Mortgage Rates Determined?

Lenders will determine your mortgage rate based on several factors — some of which you can influence and others you can’t. When you visit a mortgage lender online or in person, you’ll see some advertised rates. However, that may not be the mortgage rate you receive when you go through the pre-qualification process. This is because mortgage rates are all about risk assessment. The higher the repayment risk, the higher the interest rate the lender will charge. 

Understanding why mortgage rates can vary, and by how much, is important because even a slight increase in your rate can cost you thousands of dollars in interest charges over the loan’s term. The good news is that mortgage rates are negotiable. You should compare rates from several lenders, and see if one will sweeten its offer with a lower rate.

Who sets mortgage rates?

Multiple entities play a role in setting the mortgage rates you see today. While no single organization controls these rates, several key players influence how they’re determined.

The Federal Reserve doesn’t directly set mortgage rates, but its decisions significantly impact them. When the Fed raises or lowers the federal funds rate, mortgage rates typically follow the same direction, though they don’t move in lockstep.

Government-sponsored enterprises, like Fannie Mae and Freddie Mac, also influence rates by purchasing mortgages from lenders, creating a secondary market that affects pricing. Additionally, the bond market plays a crucial role, as mortgage rates often track the yields on 10-year Treasury bonds.

Individual lenders ultimately set their own rates based on market conditions, their business costs, and their appetite for risk. This means you might see slightly different rates from different lenders on the same day.

What affects mortgage rates?

Understanding what impacts your mortgage rate can help you make informed decisions and potentially secure better terms. Here are all the factors that affect mortgage rates: 

Economic factors

Broad economic conditions create the foundation for all mortgage rates. These factors operate beyond any individual’s control but can significantly influence the rates lenders offer.

Overall economy

When the economy is strong and growing, mortgage rates tend to rise. During economic uncertainty or downturns, rates often fall as investors seek safer investments like bonds. Economic indicators, such as GDP growth, consumer confidence, and retail sales, all contribute to this relationship.

Inflation

Interest rates usually move in the same direction as inflation. When prices for goods and services rise, lenders demand higher rates to maintain their purchasing power over time. The Federal Reserve closely monitors inflation and adjusts monetary policy accordingly, which indirectly affects mortgage rates.

Job market

Employment levels directly correlate with mortgage rates. Strong job growth typically leads to higher rates, while rising unemployment often results in lower rates. When more people are working and earning steady incomes, there’s greater demand for mortgages, which can push rates higher.

Federal Reserve

While the Fed doesn’t set mortgage rates directly, its monetary policy decisions have a profound impact. When the Fed raises the federal funds rate to cool an overheating economy, mortgage rates typically rise. Conversely, when the Fed cuts rates to stimulate economic growth, mortgage rates often decline.

Personal factors

Your individual financial profile plays an equally important role in determining your specific mortgage rate. These are areas where you have direct control and can take steps to improve your terms.

Credit score

This is the single biggest factor — and, of course, the higher your credit score, the better. Most lenders gauge creditworthiness using FICO scores, which range from 300-850. A score of 720 is the historical threshold where you can expect to get better rates without any negative rate adjustments by the lender. However, you can often get even better rates with scores in higher brackets.

If your score is too low, you may not qualify for a mortgage at all, or you may have to put more down, depending on the loan type. Learn more about how you can get the lowest mortgage rate.

Loan-to-value ratio and down payment

Your loan-to-value (LTV) ratio is another big factor affecting your rate, especially if you have less-than-perfect credit.

LTV describes the ratio between the value of your home loan and the home’s value. The larger your down payment, the less you’ll have to borrow against the value of the home, thus lowering your LTV.

Lenders consider borrowers with lower LTV ratios less risky because they have more equity in the home and are less likely to default on their mortgage.

Your LTV ratio will also determine whether you have to pay mortgage insurance. For conventional loans, borrowers who want to avoid paying private mortgage insurance will generally need to make a down payment of 20% of the value of the home. FHA loans will allow you to have a loan-to-value ratio of up to 96.5%. USDA, VA and other specialty loan types may allow for a 100% LTV for a purchase loan but may require a funding fee.

The lender you choose

Lenders weigh several factors in determining your interest rate, including:

Loan purpose

Your interest rate can vary depending on whether you’re purchasing or refinancing an existing mortgage. Some programs offer incentives for purchasing a home, and almost all lenders have a higher interest rate for a cash-out refinance. The interest rate you receive will still depend primarily on your credit score and LTV ratio.

Loan type

Rates also depend on the type of mortgage loan you choose. Fixed-rate loans will have higher interest rates than the initial interest rates on an adjustable-rate mortgage (ARM). However, adjustable rates are usually higher after the initial fixed term ends. While adjustable rates can vary greatly, 3-, 5-, and 7-year ARMs tend to have an interest rate about 0.5% lower than equivalent 30-year fixed-rate mortgages.

Loan term

Mortgages come with either short or long terms. The shorter the term, usually the lower the rate. Loans with 20-, 25-, and 30-year terms have pretty similar rates, while 10- and 15-year loans are comparable to each other and have rates about 0.5% lower than the 30-year group.

Loan amount

Smaller loan sizes often have slightly higher interest rates to cover the fixed costs lenders pay to obtain and manage the loan during repayment. Whereas loans on the higher end of the conforming loan range (traditional Fannie Mae and Freddie Mac loans) will sometimes have a slightly lower interest rate because they are a little more profitable than smaller loans. Jumbo and super-jumbo home loans, which exceed the conforming limits set for Fannie Mae and Freddie Mac will generally have higher interest rates.

Location

How lenders evaluate risk can vary by state due to differences in local laws and economic conditions. Some states have longer foreclosure timelines or more borrower protections, while others may have faster processes. In New York and New Jersey, the foreclosure process can take several years, which could lead lenders to charge slightly higher rates to offset the increased risk and cost. Lenders typically take these regional factors into account when determining their rates and policies.

Taking your next step toward homeownership

Understanding how mortgage rates are determined puts you in a stronger position as you navigate the home-buying process. While you can’t control economic factors, you can work on improving your credit score, saving for a larger down payment, and shopping around with multiple lenders.

Use our BuyAbility tool to get a personalized mortgage rate estimate based on your unique financial situation. When you’re ready to take the next step, check out our various mortgage options and get approved with us at Zillow Home Loans*.

Remember, even small differences in mortgage rates can significantly impact your monthly payment and the total amount you’ll pay over the life of your loan. Taking the time to understand these factors and improve where you can will serve you well on your homeownership journey.

*Zillow Home Loans; an equal housing lender. NMLS #10287