How Are Mortgage Rates Determined?
Your credit score, down payment and loan term are key ingredients that help determine your mortgage rate — but you’re not the only cook in that kitchen. Economic uncertainty or a lender’s business plans may add a dash of unexpected flavor to your recipe, making your interest rate hard to predict. But understanding how everything blends together can help you find a mortgage rate that suits your financial needs.
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What factors determine your mortgage interest rate?
Lenders consider two major factors when determining your mortgage rate:
- How likely you are to repay the loan
- What’s going on in financial markets and the larger economy
The first factor — your ability to repay the loan — is based on how well you’ve managed your finances, including your credit score, savings, total debt and income.
The second factor is influenced by the performance of the economy, inflation and the Federal Reserve’s monetary policy — in other words, things that are out of your control. Financial markets and economic indicators constantly fluctuate, making it even more important for you to focus on keeping your financial house in tip-top shape.
Things you can control: Your financial choices
Lenders offer mortgage rates based on the likelihood you’ll pay back borrowed money. History and data show that a high credit score and large down payment reduce the odds you’ll have trouble making your mortgage payment. As a result, the lowest rates typically go to the least risky borrowers.
The factors below are ranked based on the impact they’ll have on your mortgage interest rate:
1. Credit score
Mortgage lenders rely heavily on your credit score to determine your rate. How you’ve paid credit accounts in the past is a good indicator of how you’ll handle a mortgage. To boost your credit score, pay your debt on time, keep revolving (credit card) debt balances low and avoid opening multiple credit accounts at once.
Tip
You’ll need at least a 780 credit score to get the best conventional mortgage rates.
2. Down payment and LTV ratio
Your down payment has the second largest effect on your mortgage rate, especially if you’re taking out a conventional loan. The more money you put down, the easier it is to quickly pay off your loan balance if you have to sell your home later. Because that makes you less of a risk to lenders, they’ll typically offer you lower rates.
If you’re refinancing, you may hear the term “loan-to-value (LTV) ratio.” Your LTV ratio represents how much of your home’s value you’re borrowing. For example, if you borrow $300,000 on a home worth $375,000, your LTV ratio is 80%. In general, the lower your LTV ratio, the lower your mortgage rate will be.
3. Occupancy
The word “occupancy” is a lender term for how you plan to use your home. The best mortgage rates go to borrowers who intend to live in a home as a main or “primary” residence.
Homeowners tend to protect their investment in their primary home over second homes or ones they rent out. As a result, lenders charge higher rates for investment properties and vacation homes to cover the risk you might bail on the mortgage payments in a financial emergency.
4. Loan term
Your loan term is the number of years it takes for you to pay off your loan. A shorter-term loan builds equity faster and allows you to pay off your lender quicker, both factors that lead to a better rate on 15-year versus 30-year mortgages.
5. Fixed rate vs. adjustable rate
Most lenders quote fixed mortgage rates because consumers generally prefer the stability of a rate and payment that doesn’t change. However, when fixed rates are high, your lender may offer you an adjustable-rate mortgage (ARM) with a lower “teaser” rate to save you money for the first three to 10 years of the loan term. Once the initial low-rate rate period is over, your rate could shoot up depending on the type of ARM you choose.
6. Loan purpose
You’ll need to tell the lender the reason you’re taking out a mortgage. Lenders may offer special rates or closing cost discounts if you’re buying a home, especially if you’re a first-time homebuyer.
If you’re refinancing your current loan to reduce your mortgage rate or loan term, you’ll get the best refinance rates. Meanwhile, tapping equity with a cash-out refinance usually comes with a significantly higher rate if you’re applying for a conventional loan.
Why are cash-out refinance rates higher than other rates?
A cash-out refinance involves converting home equity into cash by borrowing more than you currently owe. The higher rate covers the lender’s risk you might default, because you end up with a higher mortgage payment and less home equity.
7. Property type
Because your loan is secured by a home, the type of home you purchase is another factor that can impact your mortgage rate. Single-family homes are considered the least risky for lenders if they have to foreclose and resell to recoup their investment. Expect a higher rate for the following property types:
- Condominiums
- Multifamily homes (Two to four units)
- Manufactured homes
Things you can’t control: Economic events and financial markets
Consumers are focused on the terms of their own mortgages, while investors look at mortgages as fixed-income investments. When they front a lump sum to you, they expect to be paid interest over the term of the loan.
The cost of the money they lend you depends on a number of factors, including:
1. Economic reports and markets
Every month, investors analyze a variety of economic reports for signs of strength or weakness in the economy. The “nonfarm payroll” report — commonly known as the jobs report — is important because it gives traders a look at job growth in the United States. A strong job market is usually bad news for interest rates because it often leads to inflation (more on that below).
For a hint about the direction of interest rates, keep an eye on the bond market. If the yields are headed higher, mortgage rates will probably follow their lead. If they drop, rates will usually dip as well.
2. Inflation
In the economic world, inflation measures how much the costs for goods and services increase over a specific time period. You may see inflation in the form of higher grocery, gas and house prices. Inflation is bad for mortgage rates, because it often leads to increases in the federal funds rate (the target rate banks use to lend to each other).
3. Federal Reserve monetary policy
The Federal Reserve is the central bank of the United States and its primary purpose is to keep the economy stable by setting monetary policy. If inflation rises too fast, goods and services become more expensive for both consumers and businesses.
One strategy the Fed uses to combat inflation is to increase the federal funds rate to cool off the economy and reduce inflationary pressure. Lenders generally pass those increases on to consumers in the form of higher rates for all types of loans, including mortgages.
4. Lender pricing models
Mortgage companies set up “pricing models,” based on how many loans they want to originate and how much profit they want to make. A lender with a higher profit margin is likely to offer a higher rate, which they may justify based on a higher level of service.
Other lenders specialize in being “price leaders,” and may offer very low rates to high-credit-score borrowers with a digital loan process. Lenders can adjust their model at any time, which is why you should shop with at least three to five lenders to find your best rate. You won’t know which lender is the best fit unless you’ve reviewed loan estimates from several different companies.
Tip
Once you choose the loan estimate at a mortgage rate that fits your needs, lock in your rate — otherwise it’ll be subject to market changes.
How to get the best mortgage rates
To get the best rate, focus on making sure your personal finances are as solid as possible – a stellar credit score and a large down payment on a single-family home will make you a top candidate.
But there’s a catch: You still need to shop around.
LendingTree studies show that borrowers who do the extra comparison legwork win the low-rate race — and the prize is a lower monthly payment and thousands of dollars of interest savings over your loan term.