The truth about how mortgage rates are made [VIDEO]

Maggie Overholt
The Mortgage Reports editor

How are mortgage rates determined?

If you’re in the market for a home loan, you’re probably thinking about this question.

Why is my interest rate what it is? How can I get a lower rate? And how are mortgage rates set, anyway?

The short answer is that mortgage rates depend on many factors. Your rate incorporates everything from your credit score to the U.S.-China trade war.

In other words, there’s a lot you can’t control when it comes to mortgage rates.

But, all other things being equal, you can control the lender you work with. Comparing rates from different companies is the only way to make sure yours is the lowest.

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Mortgage rate movements are a mystery to most home buyers — even the experienced ones.

And it’s no wonder. Rates on a 30-year mortgage might be 3.8% one day and 4% the next. One lender might quote you 3.99%, while another offers 3.75%. And things like Fed meetings can throw the whole rate market off-kilter.

Luckily, you don’t have to be an interest rate expert to get the best mortgage rate. You just need to know the basics.

Here, we break down how mortgage rates move, how they’re set, and how you can use this information to secure a lower rate for yourself.

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Video: How mortgage rates are made

First things first, what are mortgage rates?

Your mortgage rate is the interest you pay over the life of your home loan. Rates are calculated as a percentage of the total loan amount. So if you have a $200,000 mortgage and a 4% interest rate, you’ll pay $8,000 in interest each year.

The goal as a mortgage shopper is to get the lowest rate possible.

Even a seemingly-tiny rate change can make a big difference in what you pay over a 30-year loan. Take a look at one example:

Loan amount $200,000 $200,000
Mortgage rate 3.625% 3.75%
Total interest paid over 30 years $128,361 $133,446

Loan assumptions: Sample shows a $250,000 home, purchased with 20% down in Washington. Your own rate and payments will be different

In this example, the difference in mortgage rates is 0.125%. That seems minuscule. But over a 30-year mortgage, it’s a difference of about $5,000 and way more on bigger loan amounts.

So remember that when you’re negotiating your mortgage rate, an incremental change can make a big difference in what you ultimately pay.

Find out what rate you qualify for today (Sep 22nd, 2020)

How are mortgage rates set?

Every lender calculates mortgage rates a little differently. That’s why one lender might quote you 3.9%, while another offers 4%, for example.

But despite how it may look when you’re shopping, mortgage rates aren’t totally up to the lender’s discretion. In fact, the rate you qualify for is based on three main things:

  • The market (both national and international)
  • The lender
  • You

We’ll explain why each of those factors is important — and how you can use each to get a better rate.

Mortgage rates and “the market”

U.S. and global economies (a.k.a. “the market”) determine the overall interest rate environment. The market sets a baseline for mortgage rates, which lenders generally follow. Mortgage companies can go a little above or below “market rates,” but usually won’t stray from them drastically.

That’s the nuts-and-bolts version of the story.

When you dig deeper, there’s a lot going on in the market that affects mortgage rates on a daily basis.

Do Fannie Mae, Freddie Mac, or the Fed control mortgage rates?

Many people believe that the Federal Reserve, Fannie Mae and Freddie Mac, and the banks set mortgage rates.

But that’s not the whole truth. These agencies influence mortgage rates. But they don’t make them.

In other words, the Fed couldn’t sit down at a meeting with a gavel and declare 3% mortgage rates. But by dropping the federal funds rate — a benchmarker the Fed does control — it can create a low-rate environment that influences mortgage rates to drop.

Who does control mortgage rates?

In reality, mortgage rates are set by investors on Wall Street. These investors purchase mortgage debt and profit from the interest paid on it. And when demand is high from investors, rates go down. It’s basic supply and demand.

As a mortgage shopper, you want to be ready to lock when there’s high demand from investors on Wall Street. Rates could plummet on short notice — but they could rise again just as quickly.

Wall Street investors control mortgage rates, and Wall Street is volatile. If you’re a mortgage shopper, be ready to lock when rates drop.

So, how do you know when demand for mortgage debt (or “mortgage-backed securities”) is at its highest?

Mortgage rates often fall when:

  • Weaker-than-expected economic data and reports are released
  • When there’s steady or falling inflation
  • When there’s war or other political unrest in economically important areas

The theme here is uncertainty. Mortgage-backed securities (MBS) are considered a “safe” investment. And when investors are feeling insecure about markets, they purchase MBS in spades. That can push mortgage rates way down.

How mortgage rate movements work

Trying to understand how markets control mortgage rates can be a mental workout. So let’s look at an example scenario.

  • Let’s say mortgage rates are riding at 4% — historically, a very low rate
  • Factors like weak inflation, a war overseas and a predicted recession are keeping rates low
  • But one day, inflation ticks up. Economic outlook improves, and there’s a cease-fire overseas
  • Suddenly, investors want stocks instead of mortgage debt. Stocks are riskier but have bigger returns in a good economy
  • Demand for mortgage-backed securities drops
  • Mortgage rates shoot up from 4% to 5%

Investors are always looking for the safest investments with the highest returns. That could be mortgage debt one day, and something else the next. So mortgage rates are volatile.

When you think of mortgage rates being “set” by the market, don’t think of them as a fixed entity.

Instead of thinking about mortgage rates as a “set” number, think of them like the stock market, which moves up and down on a daily basis.

Instead, think about mortgage rates as you think about the stock market: A living market that ticks up and down on a daily basis in wildly unpredictable ways.

You can’t control markets, but you can choose when you lock your rate

You want to buy or refinance while there is low inflation, economic uncertainty, and surprisingly negative economic reports being issued.

You don’t have to be a financial expert to do this. Anyone can play the mortgage rate market.

  • Watch headlines on your favorite news site
  • When you see big economic news, check rates to see if they fell that day
  • If you see positive economic news, higher rates might be in the near future. It may be a good time to lock

All in all, the market plays the biggest role in what rate you get. Today, you can find rates below four percent. In the 80’s, rates were closer to 18%.

But no matter the market, you can find the lowest possible rate if you compare lenders to find the cheapest one.

How lenders set mortgage rates

Lenders don’t have full power to set mortgage rates. The market determines the overall rate environment. But lenders do have some power to issue you a higher or lower rate than what the market dictates.

For example, one lender could charge a 3.99% interest rate, another could charge 3.625%, and yet another lender could offer you 3.6%.

Taking the first quote you’re given often results in you getting a higher rate.

Taking the first quote you’re given often results in you getting a higher rate. And yet, about 50% of people use the first lender they talk to without checking anyone else’s rates.

As a mortgage consumer, it’s important to get quotes from 3-4 different lenders so you know a good deal when you see one.

Comparing rates will also help you find a lender that specializes in the home loan program you need. For example:

  • Bank A could be competitive for FHA loans
  • Bank B is not as competitive for FHA loans — with higher rates and tougher credit score requirements
  • If you need an FHA loan and only look at Bank B, you’ll end up paying too much

It’s hard — some might say impossible — to know which lender will be best for your situation unless you’ve compared a few.

But remember how volatile mortgage rates can be. To make sure you’re getting a fair comparison, collect all your rate quotes in one day.

Compare rates from up to four major lenders by clicking here (Sep 22nd, 2020)

How you affect your own mortgage rate

Your unique situation has a big impact on your mortgage rate. In short, the less “risky” lenders think you are as a borrower, the lower rate they’ll give you.

So, what does “low-risk” mean to a mortgage lender? It means you have:

  • Strong credit — above 680 or 720 is usually best
  • Steady income — at least two years’ solid employment history
  • Low “debt-to-income” ratio — The amount you pay in recurring debts shouldn’t take up more than 43% of your monthly income
  • Perfect rent payment history — If you were renting prior to the home purchase
  • Loan-to-value ratio below 80% — If your LTV is less than 80% (meaning you made a 20% down payment or bigger) your rate might be lower than with a very small down payment of 3-5%
  • Primary residence — A home you plan to live in will get lower rates than a vacation or investment home

That’s not to say people who aren’t “ideal” borrowers can’t get a low mortgage rate.

In fact, lenders today will often consider “compensating factors” for borrowers. For example, they might accept someone with a super-strong credit score, even though they have a higher debt-to-income ratio.

Recent loan programs can help home buyers get a mortgage, even if they aren’t considered “ideal” borrowers.

And programs like bank statement loans can help self-employed borrowers or people with non-traditional income.

But the bottom line is: Rates will almost always be a little higher for these types of programs.

Remember that investors on Wall Street buy mortgages to collect interest on them. They make lending money available for thousands of new mortgages. But investors don’t want to take on risky investments.

What you can do to get a lower mortgage rate

You can’t control what’s going on in global markets. And though you can shop around, you ultimately can’t control the rate a lender offers you. But there are things you can control to get a better mortgage rate.

  • Work on your credit score. Try to get it to 720 or higher before applying. Credit makes a huge difference in your mortgage rate
  • Buy a single-family home if possible. If your goal is to get the lowest rate, it’s important to know that condos and multi-family homes typically have higher rates
  • Consider asking a co-signer to help. If you’re really ready to buy, but aren’t quite “there” credit-wise, a co-signer can help you get a lower rate
  • Save for a bigger down payment. A bigger down payment always means a lower rate

Most people are surprised to hear this, but having a bigger down payment affects your rate less than having a higher credit score or “safer” property type.

So if possible, it’s still worth saving up to get your down payment from 5% to 10%, or 10% to 20%. But focus on those other areas first. And don’t let a smaller down payment stop you from buying a home when you’re ready.

What are mortgage rates today?

Today’s mortgage rates are low. And 30-year fixed rates are predicted to hover around 3.6% to 3.7% through 2020. So if you’ve been thinking about buying a home, now is a good time to lock a low rate.

You can get started using the link below.

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