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Understanding Mortgage Rates

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how mortgage rates work

Because a mortgage is so large, and the term of repayment stretches for decades, your interest rate is vital. Qualifying for the best mortgage rate can save you hundreds of thousands of dollars over the life of your home loan. Once you understand how mortgage rates work, it’s possible for you to use that knowledge to get the best possible rate – and save money on your home purchase.

How mortgage rates are set

The first step to understanding mortgage rates is to know how they are set. Mortgage rates are generally offered in eighths, so you’d see 4%, 4.125%, 4.25%, 4.375%, 4.5%, 4.625%, 4.75%, 4.875%, and so forth. There are two main parts to your mortgage rate. The first is the market rate for mortgages, and the second is your individual situation and what that means in terms of qualifying for the lowest market rate.

Will mortgage rates move up or down?

If you are trying to figure out if you should get a mortgage now, whether you want to buy a home or whether you want to refinance, you can look to the economy to see whether a trend is developing that will move rates in one direction or another. You could also look at the following two indications of where mortgage rates are headed:

Treasury bonds: One of the biggest factors that influence the market rate for mortgages is the yield on the 10-year Treasury bond. In general, people tend to refinance their mortgages, or sell their homes and buy new homes, in 10-year cycles. This doesn’t always hold true, but you can expect to see cycles of seven to 10 years for mortgages, so the 10-year Treasury bond is a pretty good measure if you want an idea of what’s happening.

If the yield goes up on 10-year Treasury bonds, then mortgage rates are likely to move higher. Likewise, if bond yields move lower, mortgage rates are likely to head lower as well. A good rule of thumb is to expect a spread of between 160 and 180 basis points between the yield on 10-year Treasury bonds and mortgage rates. (One basis point is equal to 0.1%, so this means a difference of between 1.60% and 1.80%.)

This means that if the 10-year Treasury yield is at 2.4%, you can expect to see mortgage rates at right around 4% to 4.25%. Of course, sometimes the spread widens or narrows, so it’s never going to be completely predictable. But you can get a general idea of which way mortgage rates are likely to head by looking at Treasury yields.

Be sure to look at the yields, though, because prices move inversely to yields. This means that when bond prices rise, yields (and mortgage rates, usually) go down. It’s important to understand this inverse arrangement between bond prices and bond yields.

Mortgage-backed securities: These investments offer another look at where mortgage rates might be headed. Mortgage-backed securities are investments that are made up of “pools” of similar mortgages. Basically, mortgages are bundled into securities that can then be traded. This provides an investor a way to invest in mortgages without taking on the entire risk that one will default.

For example, say a bank lends someone $150,000 for a home. The bank then offers to sell you that same mortgage for $155,000. The bank pockets the $5,000 profit, and you have the chance to earn a bigger return, since the yield might be 3.5%. Over the life of the loan, you stand to make back more than that $5,000 extra you paid. But what if the borrower defaults? The bank has already made its money, so you’re at risk. In order to reduce the risk to you, and make the situation more attractive, loans are bundled together. That way, the combined effect means that you can reduce some of the risk if you invest in mortgages.

Watching mortgage-backed securities can also give you an idea of what’s happening with the market, since the gains and losses there often indicate what’s happening with supply and demand in terms of the mortgage market – and that can provide you with clues as to whether or not rates might rise.

What influences the market mortgage rates?

But why are mortgage rates moving up or down? Understanding what influences the market mortgage rate can help you get an idea of whether you can expect to pay more or less. It’s important to understand that the mortgage market is complex, and entwined with the economy – which is also complex. There is no way to completely predict what will happen next, nor can you pinpoint exactly how certain factors will influence mortgage rates.

However, there are some items that are more likely than others to make a difference in what happens to mortgage rates. Some of the factors that influence market mortgage rates include:

Economic activity: One of the biggest factors in what happens with mortgage rates is economic activity. We get a lot of economic measures, from readings of the Consumer Price Index, to measures of Gross Domestic Product, to information about Consumer Confidence. All of these measures influence mortgage rates.

Basically, when the economy is in good shape, demand for mortgages increases, and interest rates move higher in response, since incentive to encourage people to buy homes isn’t needed as much. When the economy slows down, mortgage rates drop as lenders try to attract borrowers.

Federal Reserve: When the Federal Reserve makes policy announcements, or releases minutes from its meetings, mortgage rates might change. This is because the Fed offers guidance on expected economic performance, and policy decisions in conjunction with those expectations. If the Fed expects the economy to pick up the pace, then mortgage rates are likely to increase as well.

The Federal Reserve can also impact mortgage rates by purchasing mortgage-backed securities. As the Fed buys these securities, supply dwindles, forcing prices higher. And, as we know, with bond securities and mortgage-backed securities, price and yield move opposite to each other. So as the prices rise on mortgage-backed securities, the yields drop – and yields drop for mortgages, since banks can sell the mortgages at a higher price and offer lower rates to borrowers.

Loan originations: Demand for mortgage loans also plays a role in how mortgage rates move. If loan originations are on the rise, then the rules of supply and demand are in effect, and that means that yields can rise, too, since there are enough people interested in buying homes that they are willing to accept higher rates.

Housing market: The housing market also plays its role. If home prices are high, then some buyers might not be able to make purchases. They might not be able to afford the mortgages and the rates being charged. When real estate slows down, prices come down, and often mortgage rates drop as well, in an effort to make home purchases more attractive to consumers.

Fannie, Freddie, and Ginnie: There are also government-sponsored enterprises that can impact market mortgage rates. Fannie Mae, Freddie Mac, and Ginnie Mae are enterprises that buy loans from lenders, and then service them. The idea is that these loans can be purchased from lenders and the lenders then have capital free to make more loans.

The liquidity of the mortgage market is due, in large part, to these enterprises. And, in fact, the government takes great pains to ensure that they remain afloat. Roughly half of the $13 trillion in mortgages in the United States are owned or guaranteed by Fannie Mae and Freddie Mac.

Individual market rates

Location also plays a role in mortgage rates. You might see slight differences in mortgage rates offered in different locations. In places where the mortgage market is struggling, rates might be lower than in areas where the market is recovered.

Each week, Freddie Mac does a survey of mortgage markets across the country and then averages them out to get a quasi-official mortgage rate reading for 30-year loans and for 15-year loans. It’s important to realize that when you see news about “this week’s mortgage rate” you’re looking at an average, and that individual markets have their own rates, based on local conditions as well as the wider economic considerations.

Your personal situation and mortgage rates

Realize that the market rate for the nation and for your local area is just a starting point. The ultimate influence on whether you pay the best available rate, or whether you are charged more, is your own situation.

Lenders take a look at your individual situation and use that to determine whether or not you will get the best possible rate, as determined by the market, or whether you will pay more. If you are seen as a bigger risk, you will pay a higher interest rate for your loan, since the lender is taking on a bigger risk that you will default on the loan. Here are some of the factors in your personal situation that impact your mortgage rate:

Your credit score: This is a three-digit summary of your financial reputation. Your credit score represents your ability to handle credit. If you have a higher score, the lender thinks it is likely that you will repay your loan, and is more willing to charge you a lower rate.

Loan term: The longer your loan term, the bigger the chance that you will default. If you choose a shorter loan term, and a faster payoff, you will be rewarded with a lower interest rate.

Down payment: You pay less when you have more “skin in the game.” The more you can put down for your down payment, the more you are likely to save in terms of interest. A 20% down payment can mean a great mortgage rate.

Points paid: You can also pay points in an effort to reduce your mortgage rate. You can pay money up front, and see a reduction. A point represents 1% of your home’s purchase price. For each point you pay, you can expect to see a reduction of about 1/8 of your loan rate. So, if you are buying a home for $200,000, one point is $2,000. If your loan rate is quoted at 4%, you can get it down to 3.875% by paying that $2,000. Pay two points ($4,000) up front, and you could see it drop to 3.75%.

Before you pay points, though, you should run the numbers to see if the money you pay up front is worth it. You need to be in the home long enough to recoup the money you pay out.

Bottom Line

There’s a lot that goes into mortgage rates. However, once you understand what influences rates, and when you realize that you can get a good idea of whether they are going to go up or down, you can make a more informed decision about the right time to buy.

About Miranda Marquit


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