Interest rates are a big concern when mortgage shopping, but how are interest rates determined? A lower interest rate makes monthly mortgage payments more affordable while a higher interest rate can make it difficult to get approved for a loan.
Interest rates are influenced by a variety of factors and can affect the cost to borrow money to purchase a home and even the value of real estate. If you plan to purchase a home or refinance, you should know how interest rates are determined and the steps you can take to lower your rate.
Who Determines Interest Rates?
Mortgage interest rates are affected by factors outside of the lender’s control. The Federal Reserve doesn’t directly affect mortgage interest rates, but its decisions do influence rates.
The central bank sets the discount rate, which is the short-term interest rate at which banks can borrow money from the Federal Reserve. When the Fed raises rates, the cost to borrow money increases.
For example, the Federal Reserve adjusted its monetary policy and set interest rates near 0% in response to the pandemic in March 2020. These were the rates at which banks could borrow money to lend to consumers. Mortgage rates aren’t directly tied to the Fed’s rates, but the prime rate for mortgages will typically follow.
Mortgage rates are also connected to the 10-year Treasury note when they’re tied to the bond market. Mortgage-backed securities, also known as mortgage bonds, are sold on the bond market.
As bond rates rise, mortgage rates are lower, and vice versa. Rates rise and fall with demand.
The bond market affects mortgage rates because they attract the same type of investors — those looking for a fixed and stable return with less risk. Mortgage rates are usually lower than certain types of revolving credit but are higher than the prime rate.
What Factors Affect Interest Rates?
Mortgage interest rates are affected by factors both within and beyond your control. Lenders will quote you an interest rate depending on your level of risk.
Lenders evaluate your level of risk by measuring your credit history, ability to repay, capital, the loan’s conditions, and collateral.
Riskier consumers typically pay higher interest rates on their mortgages.
Here’s a list of the most common factors that may have an impact on your interest rate:
- Credit score: Although you may qualify for a conventional mortgage with a credit score as low as 620, consumers with higher credit scores receive lower interest rates than those with lower credit scores. You could receive a more favorable interest rate by raising your credit score before applying for a mortgage.
- Loan-to-value ratio: The LTV is calculated by dividing the amount borrowed by the appraised value of the property. In general, the lower the LTV, the greater the chance the mortgage loan will be approved and the lower the interest rate may be. You can lower your LTV by making a bigger down payment.
- Loan term: According to the Consumer Finance Protection Bureau, shorter-term loans generally have lower interest rates and lower overall costs. However, shorter-term loans also have higher monthly payments than loans with longer terms.
- Interest rate type: Whether you have a fixed-rate mortgage or an adjustable-rate mortgage (ARM) will affect your interest rate and what you pay over the life of the loan. Your initial interest rate with an ARM may be lower than with a fixed rate at first, but that rate might increase later on.
- Loan type: Rates can vary significantly by the type of loan product you choose. Rates for conforming loans, non-conforming loans, and government-backed loans are all different and have distinct eligibility requirements.
Other factors, such as inflation and the overall economy, also cause rates to move up and down.
Mortgage interest rates may rise during periods of economic growth, high inflation, and low rates of unemployment. Rates typically decline during an economic cooldown, lower inflation, and higher unemployment rates.
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How Are Different Interest Rates Determined?
The amount of interest charged depends largely in part on whether the loan is long-term or short-term, which is controlled by the federal government. Retail banks also have some control over the interest rates that they pay for deposits and charge for loans.
Long-Term Interest Rates
Long-term interest rates generally follow 10- or 30-year Treasury note yields. The U.S. Treasury Department auctions these yields and performance depend on market demand.
Lower demand leads to higher interest rates while higher demand results in lower interest rates. Long-term interest rates are usually averages of daily rates measured as a percentage.
Short-Term Interest Rates
The Federal Open Market Committee is the Federal Reserve’s monetary policymaking body, which determines short-term and variable interest rates. The FOMC meets eight times per year to discuss monetary policy and interest rates.
When the money supply is lowered, interest rates go up. As interest rates rise, there’s less borrowing from the central bank. If the FOMC wants to increase the money supply, interest rates go down and more money is borrowed.
Deposit and Loan Interest Rates
Retail banks can offer interest rates based on the overall market, the needs of the bank, and the consumer. Lower rates may be given to consumers who pose a lower risk and have a higher credit rating. Banks can also change the interest rate if a payment is missed or for certain services.
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Overall market conditions and your personal situation are what determine interest rates. While you can’t change the market, there are steps you can take to improve your creditworthiness and increase your savings to get a better mortgage interest rate.