If you’re buying a home, you probably already know you want to get the lowest mortgage rate possible. And you’ve also likely heard that mortgage rates are super low (and have been for years!) about a million times by now.
In the world of real estate, these bits of “advice” tend to get thrown around like candy, leaving buyers with the vague idea that mortgage rates are important, but very little context as to why.
So let’s back up a minute. What, exactly, is a mortgage rate? How is your rate determined? And how do you get a low rate?
These are just a few of the questions homebuyers have been asking for decades.
Unfortunately, it’s not always easy to get straightforward answers.
Mortgage rates are relatively complex. The rate you’re offered by a lender involves a lot of interconnected factors; some are within your control, and some are well outside your control.
Millions of buyers are left in the dark when it comes to their rates. In fact, around a third of U.S. homeowners don’t even know what their mortgage rate is, much less how it’s factored.
It’s finally time to cut through the confusion.
We spoke to John Boyles, HomeLight’s Head of Capital Markets, to walk us through the basics of mortgage rates, so you can make an informed decision when it comes to your home purchase.
Let’s break this mortgage rate thing down, once and for all.
Who sets mortgage interest rates?
A mortgage rate is the interest you pay on your home loan.
Let’s say you need to borrow a large amount of money to buy your dream home. Your mortgage company lends you $250,000. This $250,000 is called the loan principal.
Your mortgage rate is what you’ll pay to borrow that $250,000 over time. It’s a percentage you pay on top of the loan principal. So, let’s say you’ll pay 5% interest on top of the $250,000 principal.
When you make your mortgage payment each month, your principal and interest are rolled into one mortgage payment.
Mortgage interest really adds up over time. Even a slight change in your rate can make a big difference, adding up to tens of thousands of dollars over the life of the loan.
So where does your mortgage rate come from?
Your rate is set by your lender. They take into account a whole host of factors, including some that are outside your control (like Federal Reserve interest rates), and some you can influence (like your credit score).
Let’s walk through the major factors that go into your mortgage rate.
What outside factors influence mortgage rates?
1. The Federal Reserve overnight interest rate
“The Federal Reserve manages our national monetary policy,” Boyles shares. “Basically, they control the flow of money in and out of the U.S. economy. They set a baseline rate that most other rates are geared toward.” This rate is the overnight exchange rate, or the rate at which banks loan money to each other.
The term “baseline rate” means the Fed rate is kind of like a jumping-off point. Even if the Fed lowers interest rates to 0%, you still won’t get a 0% mortgage rate. Typically, even the lowest mortgage rates are a few percentage points higher than the Federal Reserve interest rate.
Why? It costs a lot of money to create and service a mortgage over the life of the loan. Your lender bakes some of those costs into your rate.
2. GSEs and secondary mortgage markets
Government-sponsored enterprises (GSEs) like Fannie Mae and Freddie Mac play a big part in your mortgage rate.
These government-backed agencies buy huge numbers of mortgages from lenders, bundle them together, and then sell them to investors. GSEs basically act like a middleman between mortgage lenders and investors.
They play a vital role in keeping the money flowing in the mortgage industry. Thanks to GSEs, lenders are able to free up funds to create more loans, which then makes loans more accessible to the average American.
Depending on supply and demand in secondary mortgage markets, lenders may adjust the rates they’re offering to borrowers.
For example, if rates drop too low and mortgage applications skyrocket, that may also flood the secondary mortgage market and drive down prices for mortgage bonds. This could cause lenders to raise rates for a time, while the market recalibrates.
Another big way GSEs impact mortgage rates? They are the primary purchaser of “conventional” mortgages, and in a sense, they create the lending market for those mortgages.
“Conventional” means that a mortgage meets the lending guidelines defined by these GSEs. In the US, most mortgages are conventional loans and are eventually sold off to the GSEs.
“They define the credit policies, and they set the risk standards for conventional loans. They set the criteria for borrowers,” Boyles explains. “They set pre-defined factors like credit score, loan-to-value, type of property, and things like that.” And those pre-defined factors help define the risk associated with a given borrower and how much loans with that risk profile are worth in that market.
Essentially, Fannie and Freddie define what a conventional loan is and then also create the marketplace where lenders can sell those conventional loans. Lenders making conventional loans then base their rates on the status and pricing they can receive in that marketplace.
3. Mortgage and housing market factors
Another factor affecting mortgage rates? The health of mortgage and housing markets.
For example, lenders look at the supply of housing (how many homes are on sale or being built) and buyer demand (how many qualified buyers are looking to purchase homes) to help determine rates.
“We look at the open market, what buyers are willing to pay for a mortgage at any one time,” Boyles shares. “And that changes during market hours, much like the stock market.”
Lenders also look at any current risks in lending, like how many homeowners are defaulting on their mortgage loans. When things look a little riskier, lenders may raise rates to cover that risk.
4. Lender and third-party costs
When it comes to creating mortgages, lenders have their own costs to think about.
“We look at the fees that are built in,” Boyles says.
“We look at our cost to originate, our credit risk, our default risk, our servicing risk, and everything that flows down, and we try to set our rate based on that.”
He likens these costs to what you might see in a manufacturing company.
“If you think about the cost to manufacture a car, or any other product, you have distributors. You have manufacturing people. You have parts people. You have all these ways people make a little money off that process. It’s the same thing with mortgages.”
5. Economy as a whole
The state of the global economy also plays into mortgage rates.
Mortgage lenders look at many economic factors to set rates, including:
- The health of the stock markets
- Job growth and unemployment
- National GDP
These factors help lenders determine how much risk they’re carrying at any given time. In times of economic uncertainty, like during the coronavirus pandemic, lenders may become more conservative and charge higher rates than Fed interest rates might suggest.
During slower economic times when demand is lower, lenders may lower their rates to attract buyers.
What borrower factors do lenders use to determine rates?
If all those complex outside factors are overwhelming, take heart that there’s still plenty within your control when it comes to your mortgage rate.
Your financial profile and the property you choose will play a huge role in determining your interest rate.
Keep in mind that advertised mortgage rates — those super-low rates your lender features on their site — are typically only available to certain borrowers who meet strict lending requirements.
Many borrowers will pay a higher rate than advertised. Just how much higher will depend on a few different factors.
1. Your credit and financial background
Your credit score packs a mighty punch when it comes to your mortgage rate. Lenders use your credit score to determine how likely you are to pay your home loan back on time.
The higher your credit score, the better your rate will be. If you have a lower credit score, you’ll likely pay a higher rate to make up for any additional perceived risk your lender takes on by giving you a mortgage.
2. Your debt-to-income ratio
Your lender will also need to determine how much of your income you can safely put toward a mortgage payment each month.
Enter your debt-to-income (DTI) ratio.
This looks at how much money you make versus how much you pay toward your debts each month. Your debts include credit cards, car payments, personal loan payments, and student loan payments.
Most lenders require a DTI of 43% or less. That means no more than 43% of your income should be paid toward debts each month, including your mortgage.
When it comes to your mortgage rate, it pays to have a lower DTI. The less debt you’re carrying relative to income, the lower your mortgage rate will be.
3. Your savings
Your lender wants to know they can count on you to make your mortgage payments each month.
The more you have in savings (think: those six months of emergency expenses you’re always supposed to have on hand), the more likely you are to pay back your loan and remain in good standing with your lender.
Having a solid savings can go a long way toward showing a lender you won’t miss payments, even if you lose your income or times get tough. For that reason, lenders may give better rates to buyers with strong savings.
4. Down payment
While it’s a myth that you need to put 20% down on a home to get a mortgage, it is true that making a larger down payment will help you score a better mortgage rate.
That’s because lenders look at your loan-to-value ratio when they factor your mortgage rate. We know, we know. These lender ratios are probably making your eyes glaze over at this point. But this is an important one!
Basically, loan-to-value looks at how much your lender has to loan you versus how much the home is worth. So if you make a hefty down payment — say, 30% — your lender will have to front you less money for the home. That means less risk for them, and a lower rate for you.
Note that if you put down less than 20% on a home, and you use a conventional loan, you’ll most likely have to pay private mortgage insurance (or PMI). This will also affect your monthly mortgage payments, at least until you’ve paid off 20% of the home.
5. Loan features
The type of loan you get also plays into your rate. There are a variety of loan terms and types to choose from. What’s right for you won’t be right for the next buyer.
Your rate can fluctuate based on a host of factors:
- Are you getting a conventional loan or a government-backed loan (like FHA or VA loans)?
- How long is your loan term? Thirty years? Fifteen years?
- How will you pay back your interest over time?
- Will you use mortgage points to pay down your interest rate?
- Will you get a fixed-rate or adjustable-rate mortgage?
- Are you taking out a very small or very large loan? Sometimes loan amounts that are outside the norm can come with higher rates.
Remember: your rate will ultimately reflect the risk you present to the lender. Keep that in mind as you negotiate loan terms with your lender.
6. Property type and location
Did you know lenders offer different rates in different states? Or that you’ll likely pay higher rates for a second home than for a primary residence? These nuances are always top-of-mind to lenders as they lock in your rate.
- Property type: Single-family, multi-family, condo, mobile, co-op, etc.
- Property use: Primary residence, second home, rental
- Property location: Different locations present different costs to the lender, and that means varying rates.
Expect your lender to ask what you’ll use the property for, whether it’s an investment home, and where it’s located before they offer you a rate.
How much rate variation can there be between lenders?
According to Boyles, those aforementioned lender costs and profit margins are the biggest driver in rate variance between lenders.
Basically, each mortgage company has their own business strategy for lending. That can make a big difference when it comes to your rate.
If you shop around for a lender, you could shave up to 1% off your mortgage rate, saving you $44,500 over the life of a $300,000 30-year loan.
No matter what your financial situation, it pays to compare lenders.
Are rates higher or lower for shorter/longer loan terms? Why does that matter?
The longer your loan term, the higher interest rate you’ll pay.
In general, shorter term loans have lower costs, so the savings get passed on to you through lower rates. That said, paying off the full loan amount in a shorter period can make for a pretty significant jump in your monthly payment compared to a longer term.
With a shorter-term mortgage, you’ll pay a lot less for your home over time on two fronts:
- You’ll get a lower rate to start with.
- Because interest compounds over time, you’ll pay way less of it with a shorter-term loan.
Getting a shorter-term mortgage isn’t an option for everyone because the monthly payment could be too high for you to comfortably manage, but if you’re in a position to aggressively pay down your home, you could save tens of thousands of dollars over your loan term with a 15-year mortgage.
What’s the difference between an adjustable-rate and a fixed-rate mortgage?
An ARM is an adjustable-rate mortgage. That means your mortgage rate changes over time. ARMs usually have a fixed interest rate for a set period of time, followed by periodic adjustments that tend to reflect whatever’s going on with interest rates and the economy.
For example, a 5/1 ARM means you get a fixed rate for the first five years of the mortgage, followed by a rate adjustment each year after.
With a fixed-rate mortgage, you have one fixed rate throughout the life of the loan that never changes. So long as you keep your home and your mortgage, your loan payment amount will never change (though you’ll probably have to pay more in insurance and taxes as your home value increases over time).
ARMs tend to come with lower initial rates than fixed-rate mortgages. But of course, there’s a risk in taking out an ARM. There’s no guarantee your rate will remain low after the initial fixed-rate period. You could be hit with a much higher rate once your rate begins to adjust, making your home less affordable in the long term.
How is mortgage interest paid?
How you pay your mortgage interest depends on your loan terms.
Typically, interest is amortized over the life of a loan. Your lender will provide you with an amortization schedule for loan repayment.
In your first year of homeownership, with amortization, your mortgage payments primarily go toward paying your interest. As you get deeper into your repayment schedule, you pay off more toward your loan principal each month.
However, some loans work differently. With an interest-only mortgage, you pay only the interest on your mortgage for the first 5 to 10 years. After that period ends, you move into more of a traditional mortgage payment structure.
An interest-only mortgage isn’t right for all buyers, as it can take longer to pay off your home, and therefore cause you to pay more interest on your loan over time.
Don’t be afraid to ask your lender about your amortization schedule, or to have them walk you through your repayment plan.
Where can I find the latest mortgage rates?
Ready to do your mortgage rate research?
You can see current mortgage rates and explore state-by-state rate breakdowns on the Consumer Financial Protection Bureau’s website.
If you’re curious about how different lenders compare with one another, Bankrate constantly surveys U.S. mortgage lenders and provides up-to-the-minute mortgage rates on its site.
If you’re looking for a daily breakdown on what’s going on with mortgage rates along with useful buyer-centric rate advice, look no further than the The Mortgage Reports.
How can I lower my mortgage rate?
If you’re buying a home, you’re probably wondering how you can get the best possible mortgage rate. We’ve got a few ideas.
1. Improve your credit before you buy
Raising your credit score is probably the most important thing you can do to get a better mortgage rate.
Check your credit reports, then identify and fix any problems that come up. Settle debts, dispute any errors in your reports, and avoid taking on any new debt during the period before you buy a home.
Putting all of your accounts on autopay can help you avoid credit dings from late or missed payments. Another thing you can do is pay down your debts, especially higher-impact debts, like credit cards and car loans.
Repairing your credit can take six months or longer, so patience is the name of the game here. Tiny actions can add up big, so stick with it and play the long game.
2. Compare lenders
According to a recent study, 50% of home buyers don’t shop around when getting a mortgage. But comparing lenders can pay off big time. You could shave up to 1% off your rate, and save tens of thousands on your new home.
Always apply with at least three mortgage lenders before making your final decision. And don’t worry about your credit score taking a hit: It’s a myth that applying with multiple lenders hurts your credit.
According to the CFPB, you have 45 days to shop for a mortgage, and within that window, you can apply with as many lenders as you want without it hurting your credit (other than the 5 or so points you’ll lose from your score after your first hard credit pull).
Take advantage of that mortgage shopping window, and you could seriously save!
3. Save up more for a down payment
Another option you have to get a better rate? Save up more for a down payment. This will improve your loan-to-value ratio and could score you a better rate with your lender.
However, it’s important to keep in mind that sometimes home prices can outpace what you could possibly save up for a down payment. So it may make sense to buy sooner rather than later, even if your mortgage rate takes a hit.
It’s always best to consult a trusted financial advisor before making such a huge decision. They can help you find the sweet spot between rate and down payment.
Once you buy a home, you’re not locked into your mortgage rate for life, even if you got a fixed mortgage. You can always apply to refinance your home at a new rate, provided the savings are worth it.
This might be a good option for certain buyers, like those who don’t have a ton of money saved for a down payment.
Only you can decide if homeownership is right for you at this time, and if you’re comfortable with the rate you’re offered. But bear in mind that refinance is always an option down the line if your finances improve.
5. Wait for rates to go down organically
Rates are always changing, even on a minute-by-minute basis. That can cause a lot of stress for buyers.
But it can also be a blessing. It means lower rates could always be around the corner.
If you’re not comfortable with the rate you’re offered, and you have flexibility in terms of when you buy your home, you can always wait until rates go down organically.
Even a tweet by the President can affect mortgage rates, so hang in there if you’re waiting for lower rates.
And be sure to check in frequently on the Mortgage Reports, as they give daily advice on whether to lock in your mortgage rate or wait for a better one.
Header Image Source: (Taylor Simpson / Unsplash)