How are mortgage rates determined?

Buying a home is one of the most important decisions you make in your lifetime, and getting the right mortgage for you is a crucial part of the process. A number of factors, both personal and external, can affect the mortgage rate you’re offered by lenders. Understanding how each of these factors impacts the overall cost of your loan can help you feel more confident in the mortgage loan process.

Factors affecting mortgage rates

Both personal factors and factors beyond your control affect mortgage rates.

Personal factors

There are a number of personal factors that play a role in mortgage rates, including your credit score, the loan-to-value ratio and your down payment. Borrowers who are considered a lower risk to their lender often receive better mortgage rates than those who appear to have a higher chance of defaulting.

Credit score

Your credit score gives lenders a glimpse into your creditworthiness, or how likely you are to pay back a loan based on your borrowing history. Those with higher credit scores are less likely to default on loans, so they tend to receive the lowest interest rates from lenders. As of publishing, according to FICO, the average annual percentage rate (APR) for borrowers with a credit score between 760 and 850 is 2.807%, while those with scores between 640 and 659 pay an average rate of 3.85%.

Down payment

Down payments can also be tied to default risk. Often, the higher the down payment amount, the lower the interest rate you’re offered. Lenders like to see borrowers offer their own cash upfront so they’ll have a stake in the property. If you put 20% or more down, it’s likely you’ll pay less in interest and avoid paying private mortgage insurance (PMI).

Loan-to-value ratio

Your down payment also helps lenders compute your loan-to-value (LTV) ratio, which is another factor that influences mortgage rates. Underwriters use LTV to assess the risk of a loan. This is calculated by dividing the mortgage loan amount by the appraised home value, and it reflects the portion of the appraised value that’s not covered by the down payment.

In general, an LTV ratio of 80% or lower is considered ideal. So, if you want to purchase a home that costs $200,000 and you can comfortably put down $20,000, the mortgage loan amount would be $180,000. If the home appraises for $220,000, then the LTV would be 82% ($180,000 divided by $220,000). If your LTV is higher than 80%, you can still get the loan — but it’s likely you’ll pay higher interest rates and PMI.

External factors, like the overall health of the economy, play a key role in mortgage rates.

Loan term

Your loan term can also play a big role in mortgage rates. Loans with longer terms (like 30-year loans) typically have higher interest rates than those with shorter terms. However, the monthly payment on a 15-year mortgage loan will be higher because you’re paying it off in a shorter amount of time.

Fixed vs. adjustable rates

Some lenders offer both fixed and adjustable rates. A fixed-rate loan has an interest rate that stays the same over the course of the loan. An adjustable-rate loan, on the other hand, has an initial rate that stays the same for an initial period (often five to seven years), then can change every certain number of years. There are pros and cons to both types.

Other factors

External factors, like the overall health of the economy, play a key role in mortgage rates as well. While many economists agree that some degree of rising prices is a sign of a healthy economy, too much inflation in a short period of time can leave lenders needing to raise their rates to make up for the lower purchasing power of the dollar.

The actions of the Federal Reserve (the central bank of the U.S.) also influence mortgage rates — the monetary policies the Reserve enacts have downstream effects on financial institutions. For example, it can change the federal funds rate (the interest rate banks charge one another to borrow money overnight). When this rate increases, mortgage rates tend to rise as a result.

There are other external factors, like supply and demand of housing, that have a big impact on mortgage rates. For instance, if consumer demand for housing decreases as economic conditions worsen, mortgage rates tend to fall too.

Bottom line

Mortgage rates are ever-changing. Because there are so many personal and external factors that can influence your mortgage rate, it’s important to do your own research before taking out a loan. Meet with a trusted mortgage advisor, and make sure to gather quotes from multiple lenders. Consider your individual situation as well as overall economic circumstances to decide when to lock in an agreement. This due diligence could result in substantial interest savings over the life of your loan.