How Do Mortgage Rates Work? What Makes Them Higher or Lower Day to Day?

The topic of interest rate for mortgages can feel a little like shopping for airfare. You see a price, only to find the same flight costs twice as much the next day. Then, down by half the following week – after you’ve booked your ticket. The ups and downs can be confusing and frustrating, especially if you’re not familiar with the industry and its trends.

While sudden and dramatic fluctuations aren’t always typical in the mortgage world, it’s no secret that rates can change from day to day (and sometimes even hour to hour). As a savvy homebuyer, it’s smart for you to wonder how interest rates are calculated.

What drives mortgage ratees? How is a mortgage interest rate determined? How does inflation affect mortgage rates? Sit back and discover how mortgage interest works.

How do interest rates work?

Let’s start with the basics. Interest is what you pay to borrow money. The interest rate is an annual percentage of your loan principal (the amount you borrow) that determines how much you’ll pay for the loan itself, in addition to the principal.

With every loan payment, your funds are allocated to both principal and interest. Typically, your payments start with most of the money going toward interest. By the end of your loan, you’re mostly paying down the principal. You can see how the split between principal and interest evolves over time through an amortization schedule.

Mortgage loans come in fixed and adjustable rates. A fixed rate means your interest rate will remain the same for the life of the loan. An adjustable rate mortgage (ARM) has a fixed rate for a set introductory period and then will go up or down for the remainder of the loan. In both cases, rates are calculated for the borrower based on several factors.

Who sets mortgage rates? Three key influencers

No one person sets mortgage rates. So where do rates published online come from? And why is the rate you’re quoted different? Here are three main entities, and the factors within them, that influence home loan rates.

1.   The Federal Reserve, and the economy as a whole

Technically, the Federal Reserve does not set mortgage rates. But the Fed, which serves as our nation’s central bank, raises and lowers its federal funds rate in response to economic conditions such as signs of inflation or recession. Put simply, the Fed’s adjustments are an effort to strengthen the U.S. economy.

While the federal funds rate has a more direct impact on credit cards, checking accounts, and Certificates of Deposit (CDs), mortgage lenders still pay close attention to changes the Fed makes. Mortgage rates are the result of many economic conditions throughout our country and around the world, and rising and falling rates over time is normal.

Economic conditions that can affect mortgage rates include:

• Inflation– How does inflation affect mortgage rates? Inflation is when prices across the economy slowly increase, decreasing the purchasing power of the dollar. It takes a toll on everything from your favorite foods at the grocery store to mortgage rates. During periods of inflation, rates also tend to rise.
• Housing Market – It’s supply and demand: When the housing inventory exceeds the number of homebuyers, interest rates tend to go down. When housing is limited and everyone wants to buy, rates may go up.
• Job Growth – Low unemployment levels and high wages, both indicators of strong economic growth, is typically accompanied by higher spending among consumers. A natural area of spending is in real estate, which creates demand that may drive rates up.

2.   Your lender

Though influenced by the Fed and overall economic conditions, mortgage lenders ultimately set their own rates. That’s why it can be a good idea to shop around for a mortgage and to include banks, credit unions, and online lenders in your search.

Some lenders post current mortgage interest rates and annual percentage rates (APRs) online. Think of these as base rates. The rate you receive could be higher or lower based on several additional factors (more on that below). But beware as the rate you see listed may not be the rate you can get based on your specific criteria including your credit history, amount borrowed, term or length of the loan and many other factors.

To set base rates, a lender considers economic conditions, plus:

• Risk Appetite – Lending money comes with risk. Financial institutions weigh risks and set parameters for how much they’re willing to accept. Because changing mortgage rates directly affect a lender’s earnings and value, they set limits to avoid future harm to the business.
• Demand – Lenders can reach capacity when demand is high and staff members are trying to keep up with loan processing. They may adjust rates up or down based on whether they’re trying to slow demand or attract new business.
• Origination Costs – You may be familiar with origination fees as part of typical loan closing costs. They include a variety of services including underwriting, credit checks, home appraisal, and administrative work. Essentially, it’s how much it costs a lender to process a loan. To keep origination fees competitive, a lender may build in a buffer to the interest rate to cover costs and create margin for profit.

3.   You, the borrower

Finally, there are factors you can control. The final piece of the interest rate puzzle comes down to the specifics of the loan you’re seeking and your financial situation.

• Down Payment Size – A mortgage down payment is the cash you pay up front toward a property. The remainder is financed into a home loan. A standard down payment for conventional loans is 20 percent of the agreed price, but it’s possible to pay as little as three percent down (just know it will require mortgage insurance). A higher down payment usually secures a lower rate.
• Credit Score – Your credit score is a number based on the information in your credit history. The calculation takes into account factors such as how much debt you have, the type of debt, and your repayment history. The higher your score, the more responsible a lender perceives you to be at handling debt – and that often translates into a lower interest rate.
• Debt-to-Income Ratio (DTI) – DTI helps lenders better understand your ability to afford a home based on how much of your income is already used for paying off debt. It’s calculated by dividing your debt payments by your pre-tax income. Often, the lower the DTI, the lower the interest rate.
• Loan Size, Term, and Type – Mortgages come in many shapes and sizes. A 15-year fixed-rate conventional loan for $150,000 is very different from a 5/1 adjustable-rate FHA loan. Rates can increase or decrease with different loan amounts, term lengths, and types (whether they are conventional, jumbo, or government-backed). All these variables influence each other. Your lender can suggest an optimal approach for you.
• Property Location and Type – Rates can vary based on geographic area and whether the property is a primary residence, an investment or rental property, or a piece of land. States have different laws that influence interest rates, and a lender may also take into consideration how many foreclosures are in the area. It can pay to research the area where you plan to buy before shopping around for a loan.
• Mortgage Points – You may choose to buy down your rate through points. This means you’ll pay a one-time, upfront fee in exchange for a lower interest rate. It can take years for the initial expense to pay off, so make sure to run the numbers ahead of time to ensure it’s worth it. A higher interest rate doesn’t always mean you pay more in the end.

How is a home loan rate calculated?

By now, you’ve probably guessed: There’s no magic formula for how interest rates are calculated. It’s a combination of all the factors we’ve discussed – many in your control and others not so much. The best way to obtain an optimal rate is to pay attention to trends, but focus on those within your power, like credit score, debts, and income.

And when choosing a lender, think beyond the lowest interest rate. Also, think about the relationship you want to have with them. If you feel you’re treated as a number instead of a person, or don’t feel comfortable asking questions, there may be a better fit for you someplace else.