How mortgage rates are determined and why you should care

How are mortgage rates set?

If you’re shopping for a mortgage or refinance rate, you may have noticed some odd things.

Rates can vary a lot from lender to lender. Sometimes refinance rates are different from purchase rates.

And mortgage rates may seem a lot higher today than they were yesterday.

It can seem tough to navigate the market and find a low rate when there are so many moving pieces.

But with a basic knowledge of how mortgage rates are determined, you can shop like a pro and save a lot of money in the long run.

In this article (Skip to...)

• Three factors that determine mortgage rates
• The economy
• The borrower (you)
• The lender
• Are mortgage and refinance rates the same?
• How often do mortgage rates change?
• The mechanics of mortgage rate movements
• When should you lock a mortgage rate?

The three factors that determine mortgage rates

There are three factors that influence your mortgage or refinance rate.

1. The economy
2. You
3. Your mortgage lender

We’ll describe each of these factors in detail below. But here’s a brief overview of how all three work together to determine your mortgage rate:

• The strength of the U.S. economy sets the overall tone for mortgage rates. When the economy is strong, rates tend to rise. When it’s weak, rates tend to fall
• Individual factors determine whether you're on the high or low end of the mortgage rate spectrum. For instance, say the economy is in a low-rate period, averaging around 3% for a 30-year loan. A borrower with high credit and a big down payment might get a rate closer to 2.5%, while someone with lower credit could be offered 3.5%
• Lenders offer different rates to different customers, depending on what types of loans they specialize in and how much capacity they have for new business. That’s why it’s important to shop for mortgage rates with more than one lender

If you’re currently shopping for mortgage or refinance rates, that last point is probably most important.

You can’t change the overall rate environment. And unless you have a few months, it’s tough to raise your credit substantially or save for a bigger down payment.

But you can always shop around with multiple lenders.

Odds are, there’s a lower rate out there than the first one you’re offered. You just have to look for it.

How the economy affects mortgage rates

The strength of the U.S. economy, and investor confidence, determine whether we’re in an overall ‘high-rate’ or ‘low-rate’ environment at any given time. Here’s how it works.

Mortgage-backed securities (MBS) set the tone for mortgage rates

The first thing to recognize is that most mortgages are owned by lenders for only a brief period.

Soon after closing, they’re typically bundled up within a pile of other mortgages and sold on a secondary market to investors. That way, the lender has more money to lend to the next borrower.

Each bundle is called a mortgage-backed security (MBS). An MBS is a type of bond: a fixed-income financial instrument that investors all over the world can purchase.

How the MBS market affects rates

Lenders constantly monitor the secondary market where MBS are traded.

On many days, MBS prices move hundreds of times. And, if those movements are large, lenders can change their rates multiple times as they try to keep up.

When demand for (and thus the price of) MBS goes up, mortgage rates typically go down.

This often happens when the economy is uncertain or on a downward trend.

At these times, investors want to put their money somewhere safe — and MBS are generally a safe investment. So more money will flood into the mortgage market, causing borrowers’ rates to fall.

For a real-life example of this, just look at what the Federal Reserve has done for mortgage rates during coronavirus...

The Fed’s new role in determining mortgage rates

Once the Covid-19 pandemic took hold, the Federal Reserve moved swiftly to shore up markets and confidence. Much of that went into buying all sorts of bonds, including MBS.

Normally, the Fed plays no part in setting mortgage rates. Even when it adjusts its own rates, that doesn’t directly affect those for home loans.

It might change the mood of investors in the MBS secondary market. But you shouldn’t expect to pay less for your new mortgage just because the Fed drops its rates.

But, by buying more than $1 trillion of MBS, the Fed has been affecting mortgage rates directly, though almost invisibly.

Such a big new buyer pushes up MBS prices and so reduces yields and mortgage rates.

Keep an eye on the news if you’re rate shopping

So you can see that when it comes to understanding how mortgage rates are determined, the economy is a huge factor. When it’s booming, mortgage rates are typically high. When it’s in trouble, they’re usually low.

And that applies on a daily basis. An unexpectedly great economic report can push mortgage rates higher, while one that’s spectacularly worse than expected can push them downward.

That’s why it’s important to keep an eye on the news when you’re shopping for mortgage rates. They could drop at any time, and you want to be ready to lock when the time is right.

How you influence your own mortgage rate

Lenders offer widely different rates to different applicants.

You’ll also find that various lenders will offer you different rates — even though you give them all the same information.

The reason is that lenders evaluate borrowers according to their own standards. Based on each lender’s formula, they might label you as a ‘safer’ or ‘riskier’ borrower, and they’ll adjust your rate accordingly.

Lenders employ three main criteria when deciding the rate you’ll be offered:

1. Your credit score and report — Your record for managing debts in the past is the best indicator of how you’ll handle this new debt
2. Your down payment (a.k.a. "loan-to-value ratio" or "LTV") — The more money you contribute to the purchase, the less a lender stands to lose if things go wrong
3. How big a burden your existing debts are (a.k.a. "debt-to-income ratio" or "DTI") — Someone struggling to keep up with existing monthly payments may find a mortgage and additional homeownership costs the final straw

If you’ve time, you can make all three of those better. You can work on your credit score, save a bigger down payment and pay down some debt.

Of course, it’s tough to do all three of those at once. And nobody expects miracles. But even just tweaking one, two, or all of those can earn you a lower rate and monthly payment.

The other way you affect your mortgage rate

Speaking of lower rates and monthly payments, your willingness to comparison shop for your best mortgage deal makes a big difference.

Back in 2016, federal regulator the Consumer Financial Protection Bureau (CFPB) carried out a study that found 30% of borrowers were not comparison shopping for their mortgage. Worse, more than 75% were applying to only one lender!

The CFPB report goes on:

“Previous Bureau research suggests that failing to comparison shop for a mortgage costs the average homebuyer approximately $300 per year and many thousands of dollars over the life of the loan.”

So it’s worth your time to shop around and find the lowest rate. In fact, you can rate shop in just one day and likely find a better deal than your first offer.

Why lenders offer different rates to different customers

We’ve covered the main points behind our original question, “How are mortgage rates determined?”

But that doesn’t explain why different lenders quote the same borrower such wildly different rates. So let’s tackle that.

Different lenders tend to specialize in different categories of borrowers.

• So some lenders might develop a niche market, offering deals to the most creditworthy borrowers
• Others might help people with challenging scores, maybe as low as the 500s
• And some lenders specialize in certain loan programs; like self-employed mortgages or jumbo loans

If your score is 580 and you apply to a lender that specializes in higher-credit borrowers, you’ll likely be turned down. Or maybe you’ll be offered a too-high rate that’s designed to deter you.

And the same applies if your score is 800 and you apply to a lender used to helping those with low scores. You’ll likely be offered a loan, but it might not be at the best possible rate for a borrower like you.

Another reason for variations in lenders’ rates

Lenders can also change their mortgage rates based on their current workload.

When loan officers and systems are overwhelmed by new loans, lenders are sometimes forced to manage demand by deterring new applicants. And they do that by raising their rates.

Lenders are unlikely to say, “We’re too busy for you,” or, “We currently don’t have enough money to lend to you.”

Instead, they put you off with worse deals. And if that doesn’t work, they’re happy to fit you in somehow, and pocket the extra profit you gifted them.

All this means you need to shop around for your new mortgage or refinance, even if you absolutely adore your existing lender.

Not only might your financial circumstances have changed since you applied for your current loan, so you’d be better off with a different one.

But also, yours might not be as competitive right now as when you first started working with them.

Are mortgage rates and refinance rates the same?

Normally, mortgage and refinance rates are similar. So a 30-year fixed-rate loan to buy a house should have a similar rate to a 30-year fixed-rate refinance.

But sometimes mortgage and refinance rates drift apart. And it’s usually for one of two reasons:

1. Too much demand for purchase or refinance loans — As we’ve already established, lenders sometimes put up rates to deter demand. And, if it’s refinances causing excessive work (it usually is), a lender might charge more for those
2. One's more profitable than the other — Lenders aren’t charities. They will take the chance to make more profit by prioritizing home purchase mortgages over refinances or vice versa

How often do mortgage rates change?

We’ve already mentioned that the prices and yields of MBS can change hundreds of times in a single, busy day. That secondary market is a bit like stock markets in that one respect.

And it’s true that lenders monitor changes in real-time. But they don’t issue hundreds of new rates every day.

Indeed, when things are quiet in the secondary market, they might bring out just one new rate sheet, if any.

If things are a bit more volatile in the MBS market, a lender might issue a morning and afternoon rate sheet. But that volatility would have to be extreme for them to rush out many more.

The mechanics of mortgage rate movements: What causes rates to rise and fall?

In normal times, mortgage interest rates depend a great deal on the expectations of investors.

Good economic news tends to be bad for interest rates because an active economy raises concerns about inflation.

Inflation causes fixed-income investments like bonds to lose value, and that causes their yields (another way of saying interest rates) to increase.

For example, suppose that two years ago, you bought a $1,000 bond paying 5% interest ($50) each year. (This is called its “coupon rate” or “par rate” because you paid $1,000 for a $1,000 bond, and because its interest rate equals the rate stated on the bond — in this case, 5%).

• Your interest rate: $50 annual interest / $1,000 = 5.0%

When mortgage rates fall

That’s a pretty good rate today, so lots of investors want to buy it from you.

You can sell your $1,000 bond for $1,200. The buyer gets the same $50 a year in interest that you were getting. It’s still 5% of the $1,000 coupon. However, because he paid more for the bond, his return is lower.

• Your buyer’s interest rate: $50 annual interest / $1,200 = 4.2%

The buyer gets an interest rate, or yield, of only 4.2%. And that’s why, when demand for bonds increases and bond prices go up, interest rates go down.

When mortgage rates rise

However, when the economy heats up, the potential for inflation makes bonds less appealing. With fewer people wanting to buy bonds, their prices decrease, and then interest rates go up.

Imagine that you have your $1,000 bond, but you can’t sell it for $1,000 because unemployment has dropped and stock prices are soaring. You end up getting $700. The buyer gets the same $50 a year in interest, but the yield looks like this:

• $50 annual interest / $700 = 7.1%

The buyer’s interest rate is now higher. Interest rates and yields are not mysterious. You calculate them with simple math.

When should you lock a mortgage rate?

If mortgage rates are constantly changing, how do you know when it’s time to lock in a rate?

Luckily, it’s not as tough as it sounds.

You’ll likely have a short window for rate shopping before it’s time to lock and move forward with the loan.

And in that time, you shouldn’t expect rates to rise or fall too dramatically. Movements are typically small from one day to the next.

So the decision is less about timing your rate lock, and more about choosing the right lender.

You’ll likely save more by comparison shopping than by trying to play the market, since even seasoned economists have trouble predicting how mortgage rates will move.