How Are Mortgage Rates Determined?

One of the most important aspects to successfully obtaining a mortgage is securing a low interest rate. After all, the lower the rate, the lower the payment each month.

Unfortunately, many homeowners tend to just go along with whatever their bank or mortgage broker offers, often without researching mortgage lender rates or inquiring about how it all works. Whether you’re interested in rates or not, it’s wise to get a better understanding of how mortgage rates move and why.

To put it in perspective, a change in rate of a mere .125% (eighth percent) or .25% (quarter percent) could mean thousands of dollars in savings or costs annually.  And even more over the entire term of the loan.  See my mortgage payment charts for more on that.

Mortgage rates are offered in eighths.

One thing I’d like to point out first is that mortgage rates move in eighths.  In other words, when you’re ultimately offered a rate, it will either be a whole number, such as 5%, or 5.125%, 5.25%, 5.375%, 5.5%, 5.625%, 5.75%, or 5.875%.  The next stop after that is 6%, then the process repeats itself.

3.75% 3.875% 4% 4.125% 4.25% 4.375% 4.5% 4.625%

When you see rates advertised that have a funky percentage, something like 4.86%, that’s the APR, which factors in the costs of obtaining the loan. Same goes for quintessential promo rates like 4.99% or 5.99%, which again factor in costs and are presented that way to entice you.

Those popular surveys also use average rates, which don’t tend to fall on the nearest eighth of a percentage point.  Again, these are averages, and not what you’d actually receive.

Your actual mortgage rate will be a whole number, like 5% or 6%, or fractional, with some number of eighths involved.  That’s just how mortgage interest rates operate.

So, how are mortgage rates set?

Although there are a slew of different factors that affect interest rates, the movement of the 10-year Treasury bond yield is said to be the best indicator to determine whether mortgage rates will rise or fall. But why?

Though most mortgages are packaged as 30-year products, the average mortgage is paid off or refinanced within 10 years, so the 10-year bond is a great bellwether to measure interest rate change. Treasuries are also backed by the “full faith and credit” of the United States, making them the benchmark for many other bonds as well.

[Mortgage rates vs. home prices]

Additionally, 10-year Treasury bonds, also known as Intermediate Term Bonds, and long-term fixed mortgages, which are packaged into mortgage-backed securities (MBS), compete for the same investors because they are pretty similar financial instruments.

However, treasuries are 100% guaranteed to be paid back, while mortgage-backed securities are not, for reasons such as payment default and early repayment, and thus carry more risk and must be priced higher to compensate.

How will I know if mortgage rates are going up or down?

bonds vs rates

Typically, when bond rates (also known as the bond yield) go up, interest rates go up as well. And vice versa. Don’t confuse this with bond prices, which have an inverse relationship with interest rates.

Investors turn to bonds as a safe investment when the economic outlook is poor. When purchases of bonds increase, the associated yield falls, and so do mortgage rates. But when the economy is expected to do well, investors jump into stocks, forcing bond prices lower and pushing the yield (and mortgage rates) higher.

- 10-year bond yield up, mortgage rates up.
- 10-year bond yield down, mortgage rates down.

So a good way to predict which way mortgage rates are headed is to look at the 10-year bond yield. You can find it on finance websites alongside other stock tickers, or in the newspaper.  If it’s moving higher, mortgage rates probably are too.  If it’s dropping, mortgage rates may be improving as well.

To get an idea of where 30-year fixed mortgage rates will be, use a spread of about 170 basis points, or 1.70% above the current 10-year bond yield. This spread accounts for the increased risk associated with a mortgage vs. a bond. So a 10-yr bond yield of 4.00% plus the 170 basis points would put mortgage rates around 5.70%. Of course, this spread can and will vary over time, and is really just a quick way to ballpark mortgage interest rates.

There have been, and will be periods of time when mortgage rates rise faster than the bond yield, and vice versa. So just because the 10-year bond yield rises 20 basis points (0.20%) doesn’t mean mortgage rates will do the same. In fact, mortgage rates could rise 25 basis points, or just 10 bps, depending on other market factors.

Economic activity impacts mortgage rates.

Mortgage rates are very susceptible to economic activity, just like treasuries and other bonds.

For this reason, jobs reports, Consumer Price Index, Gross Domestic Product, Home Sales, Consumer Confidence, and other data on the economic calendar can move mortgage rates significantly.

[See: Mortgage rates vs. unemployment]

As a rule of thumb, bad economic news brings with it lower mortgage rates, and good economic news forces rates higher. Remember, if things aren’t looking too hot, investors will sell stocks and turn to bonds, and that means lower yields and interest rates.

If the stock market is rising, mortgage rates probably will be too, seeing that both climb on positive economic news.

And don’t forget the Fed. When they release “Fed Minutes” or change the Federal Funds Rate, mortgage rates can swing up or down depending on what their report indicates about the economy. Generally, a growing economy (inflation) leads to higher mortgage rates and a slowing economy leads to lower mortgage rates.

Inflation also greatly impacts mortgage rates. If inflation fears are strong, interest rates will rise to curb the money supply, but in times when there is little risk of inflation, mortgage rates will most likely fall.

[10 Tips to Get a Lower Mortgage Rate]

What other factors move mortgage rates?

Issues such as supply come to mind. If loan originations skyrocket in a given period of time, the supply of mortgage-backed securities (MBS) may rise beyond the associated demand, and prices will need to drop to become attractive to buyers. This means the yield will rise, thus pushing mortgage rates higher.

But if there is a buyer, such as the Fed, who is scooping up all the mortgage-backed securities like crazy, the price will go up, and the yield will drop, thus pushing rates lower. If lenders can sell their mortgages for more money, they can offer a lower interest rate. This explains why the Fed has purchased all those MBS. They can essentially guide mortgage rates lower, and ideally keep home prices stable, by enticing more would-be buyers into the market.

Timing is an issue too. Though bond prices may plummet in the morning, and then rise by the afternoon, mortgage rates may remain unchanged. Sometimes the bond movement doesn’t make it down to the capital markets, or it simply takes more time to do so, thus rates are unaffected. Lenders are typically cautious about lowering rates, but quick to raise them. Put another way, good news can take a while to move rates, whereas bad news can have an immediate impact. Go figure.

Tip: Mortgage rates can rise very quickly, but are often lowered in a slow, calculated manner to protect lenders from rapid market shifts.

The situation is a lot more complicated, so consider this is an introductory lesson on a very complex subject. And remember, the par mortgage rates you see advertised don’t take into account any pricing adjustments or fees that could drive your actual interest up or down considerably.

In other words, YOU matter as well. If you’re a risky borrower, at least in the eyes of prospective lenders, your mortgage rate may be much higher. Things like a poor credit score and a small down payment could lead to a higher rate, whereas borrowers with stellar credit and plenty of assets will get access to the lowest rates available.

Additionally, your mortgage rate can shift quite a bit depending on if you pay mortgage points or not, and how many points you wind up paying (are they worth it?).

Lastly, rates can vary substantially based on how much a certain lender charges to originate your loan. So the final rate can be manipulated by both you and your lender, regardless of what the going rate happens to be.

Freddie Mac’s Weekly Mortgage Rate Survey (updated 3/26/15)

Below are Freddie Mac’s average mortgage rates, updated weekly every Thursday morning:

30-Year Fixed: 3.69%, down from 3.78% last week (4.40% a year ago)

15-Year Fixed: 2.97%, down from 3.06% last week (3.42% a year ago)

5/1 ARM: 2.92%, down from 2.97% last week (3.10% a year ago)

1-Year ARM: 2.46%, unchanged from last week (2.44% a year ago)

Since 1971, Freddie Mac has conducted a weekly survey of mortgage rates. These are averages gathered from banks throughout the nation for conventional (non-government) conforming mortgages with an LTV ratio of 80 percent. The numbers are based on quotes offered to “prime” borrowers, meaning best-case pricing for the most part.

As you can see, 30-year fixed mortgage rates are the most expensive relative to the 15-year fixed and select adjustable-rate mortgages. This is the case because the 30-year fixed rate never changes, and it’s offered for a full three decades.  So you pay a premium for the stability and lack of risk.

Rates on the 15-year fixed are significantly cheaper, but you get half the time to pay it off, meaning larger monthly payments.  Rates on ARMs are discounted at the outset because you only get a limited fixed period before they become adjustable, at which point they generally rise.

You can use these average rates as a starting point when determining what rate you might be offered. If your particular loan scenario is higher risk, whether it’s a higher LTV and/or a lower credit score, it will probably be priced higher.

Tip: What mortgage rate can I get with my credit score?

Record Low Mortgage Rates

In late 2012 and early 2013, fixed mortgage rates hit all-time record lows.  The 30-year fixed, as tracked by Freddie Mac, hit its lowest point ever during the week ended November 21, 2012, falling to 3.31%.  Since then, it has risen fairly steadily.

The 15-year fixed hit a record low 2.56% during the week ended May 2, 2013, the lowest point since tracking began in 1991.  It too has risen since hitting its low point.  During the same week, the 5/1 ARM also hit its all-time record low of 2.56%, though records only date back to 2005.

Finally, the one-year ARM fell to 2.41% during the week ended April 10, 2014, its lowest point on record since 1984.

Most economists don’t see rates falling back to these lows again, though anything is possible if the economy warrants such a move.

Mortgage Rate Predictions for 2015 and 2016

Wondering if mortgage rates are going up in 2015? Wonder no longer. The following are 2015 mortgage rate predictions for the 30-year fixed from well-known groups in the industry. Take them with a grain of salt because they’re not necessarily accurate, just forecasts for future movement.

Fannie Mae mortgage rate forecast: 3.9% in Q1, 4.0% in Q2, 4.1% in Q3, 4.2% in Q4 (4.4% in 2016)
Freddie Mac forecast: 3.9% in Q1, 4.1% in Q2, 4.3% in Q3, 4.5% in Q4 (4.7% Q1 2016, 4.9% Q2 in 2016)
Mortgage Bankers Association (MBA) forecast: 3.9% in Q1, 4.3% in Q2, 4.7% in Q3, 4.8% in Q4 (5.2% in 2016)
National Association of Realtors (NAR) forecast: slightly below 5% this year, 6% in 2016

In other words, mortgage rates are projected to go up, but not by a lot in 2015. The same goes for 2016, relatively limited movement, but upward trajectory.

Read more: What mortgage rate can I expect?

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