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How are mortgage interest rates set by lenders?

November 8, 2022, 11:13 PM UTC
Illustration of a yellow interest rate trend line with the outline of a house in the middle of it and an arrow pointing up at the end.
A variety of factors impact mortgage interest rates including your personal financial profile and market conditions.
Illustration by Fortune

When developing a home-buying budget, it’s important to understand that there’s a variety of factors to consider beyond just a property’s list price. Mortgage interest rates are chief among them. 

Interest rates have a major impact on your monthly mortgage payment and for many buyers, they can be the deal breaker when it comes to a home’s affordability. All of which makes it important to understand how mortgage rates are determined and the factors that contribute to the rate you’re offered.

What determines mortgage rates?

Various factors influence mortgage interest rates and generally fall into two primary categories: current market or economic conditions and your personal financial profile as an individual. 

Some examples of market conditions that can impact mortgage interest rates include inflation and the actions of the Federal Reserve. While things like your credit score, down payment, and loan-to-value (LTV) ratio are among the personal factors that play a role in the interest rate you’re offered.

Personal factors that influence your interest rate  

As lenders assess your mortgage application and thus your ability to repay a mortgage, they review your finances carefully, combing over such things as your track record of paying bills, the down payment you bring to the home purchase, and your current debt levels.

1. Your credit score 

Your credit score is one of the most critical elements of a lending application. “A credit score is a tool that helps assess historical ability and willingness to repay a debt. The lower the score, the greater the risk of delay or default,” says Mike Hardy, managing partner for national lender Churchill Mortgage.

Because of this, it allows lenders to immediately get a sense of how responsible you are with your finances and debts—and thus how much of a lending risk you may be. For these reasons, credit scores, which range from 300 to 850, play a significant role in the interest rate you’re offered.  

“The higher your credit score, the better your chances of approval at a favorable interest rate,” says Rob Cook, vice president, Discover Home Loans.

Having a strong credit history, one that includes a lengthy track-record of consistently paying bills in a timely manner and maintaining low balances on lines of credit, drives your credit score upward. This is generally the type of profile prospective lenders like to see.

For example, your FICO score—which is one of several credit-scoring models—is made up of the following core components: Payment history (35%); Amounts owed (30%); Length of credit history (15%); New credit applications (10%); and Credit mix (10%).

Before applying for a mortgage, it’s a good idea to check your credit score and do what you can to improve it if there are any areas of concern. If you still have some time before you need to apply for a mortgage, actively work on boosting your score.

2. Your LTV ratio

Yet another consideration for lenders when developing interest rate offers is what’s known as the applicant’s LTV. This is essentially a comparison between the amount of the loan you’re seeking and the value of the property you hope to purchase. 

Applicants who have a more substantial down payment for their home purchase—which lowers the amount to be borrowed from a lender—have what’s known as a lower loan LTV ratio. This is a good thing from the lender’s perspective.

“Loan-to-value measures along with credit score and other metrics play a large role in determining what rates you are eligible for,” explains Cook. “Banks know that a ‘good’ combined loan-to-value ratio, usually 80% or less, means a borrower is less likely to default on a loan.”

To calculate LTV, you simply divide the loan amount being sought by the appraised value of the home, says Brandon Snow, executive director for direct to consumer originations at Ally Bank. For example, if you’re applying for a $160,000 mortgage loan and the home you want to buy is valued at $200,000, then your LTV is 80%. In this scenario, you’d be borrowing 80% of what the home is worth.

3. Your down payment

The size of the down payment on your new home also plays an important role in your interest rate. Generally, the more substantial the down payment you make, the lower your mortgage interest rate is likely to be. This is because lenders consider applicants who have a more sizable down payment to be a lower risk.

“The larger your down payment, the lower your loan-to-value ratio, which impacts your eligibility and what rates are available,” explains Cook.  

While a 20% down payment is not always required to buy a home, having this amount available can help you obtain a much more competitive interest rate. It’s also worth noting that applicants who do not have a 20% down payment may also be required by lenders to obtain private mortgage insurance (PMI), a cost that’s added to your monthly mortgage payments. PMI is insurance designed to protect lenders should the borrower default on the loan. 

Market conditions that impact interest rates

There are also factors impacting mortgage interest rate offers that have little to do with you, your credit score, down payment or any other part of your financial profile. These variables are beyond your control.

1. The Federal Reserve 

While the Federal Reserve does not specifically set mortgage interest rates, its actions play a role in the rates that lenders offer. 

In a very simplified sense, what the Federal Reserve does is adjust what’s known as the federal funds rate or benchmark rate, which is the short-term loan rate banks charge each other. The federal funds rate is adjusted in response to evolving economic conditions. And when changed, it impacts what consumers ultimately pay to borrow money.

“When the federal funds rate increases, it becomes more expensive for banks to borrow from other banks. Those higher costs may be passed on to consumers in the form of higher interest rates on lines of credit, auto loans and to some extent mortgages,” says Cook.

2. Inflation 

Market conditions also include inflation, which impacts home prices and mortgage interest rates. “Inflation reduces the value of the dollar, which means it costs more to purchase things. In times of high inflation, mortgage interest rates tend to rise,” says Snow.

Interest rates go up amid such conditions because lenders also need to make money, adds Jeffrey Taylor, member of the board of directors of the Mortgage Bankers Association (MBA). “As the purchasing power of the dollar is eroded, mortgage lenders have to increase interest rates to ensure their interest returns a profit, or at this moment in time, a break even action.”

And here too, the Federal Reserve plays something of a part in your mortgage interest rate. That’s because when inflation trends upward too steeply, the Federal Reserve will step in and try to bring things under control by increasing the benchmark interest rates, thus making it more expensive to borrow and spend money.

“The Fed adjusts its benchmark rate as a means of spurring economic growth, by lowering the benchmark rate,” continues Snow. “Or [it will seek to slow] economic growth if inflation is increasing too quickly, by raising the benchmark rate, as we’ve seen recently.” 

3. Economic conditions

Beyond the issues already mentioned, there’s a handful of other economic and market realities that may influence the mortgage interest rates that are available at any given time, says Taylor.

Some of these additional factors include the rate of economic growth, the bond market and overall housing market conditions—meaning the available supply of homes for sale and the demand to purchase those homes.

“Each one on their own has impacts on the housing market and together—if one or more are off—it can have a compounded effect,” explains Taylor.  

Does everyone get the same rates? 

Because there are so many different factors involved in coming up with mortgage interest rate offers for individual applicants, not everyone gets the same offer. For this reason, it’s important as a consumer to shop around with multiple lenders to ensure that you’re accessing the most competitive rate possible—as well as improving your own financial health if need be.

“As a consumer, you have the right to choose the best loan for you. Shopping around is essential to making a well-informed decision on which lender, loan type, and rate is best for you,” says Valerie Saunders, board member with the National Association of Mortgage Brokers. “Don’t just look at one option.” 

Is it possible to estimate your interest rate?

Current interest rate information is widely available online. Often you can visit a lender’s website directly—such as Bank of America or Discover Home Loans—to find out what their current mortgage interest rates are, which can help you estimate what you might be offered. 

There are also mortgage payment calculators—also available online— that include interest rates in their calculations once you provide a bit of basic information, such as down payment and home price. As you embark upon home shopping, it’s a good idea to do your research and find out what your interest rate and mortgage payment might be.

You might even consider getting pre-approved for a mortgage with various lenders, to find out what rates you might be offered.

The takeaway

Mortgage interest rates can make a big difference in your ability to purchase the home of your dreams. And often it can be puzzling trying to understand how lenders come up with the rates you are offered. 

While the market conditions that impact interest rates are beyond your control, there are many parts of your personal financial picture that you can focus on and improve in order to increase your odds of being offered a competitive interest rate.

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