How Are Mortgage Rates Determined?

One of the most important aspects to successfully obtaining a mortgage is getting the best interest rate. For most homeowners, this means securing the lowest, fixed interest rate (no negative amortization!).

Many homeowners rely on their bank or mortgage broker to secure their interest rate, often without researching mortgage lender rates or inquiring about how they move. Whether you’re interested in rates or not, it’s wise to get a better understanding of how mortgage rates move, and why.

After all, a change in rate of a mere .125% to .25% could mean thousands of dollars in savings (or costs) each year.

So, how are mortgage rates determined?

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 very 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?

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 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.

What other factors move mortgage rates?

Factors 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. Go figure.

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.

Economic activity impacts mortgage rates.

Mortgage rates are more susceptible to economic activity than treasuries, mainly because the average consumer or homeowner may lose their job and be unable to make their mortgage payment, while the US government typically doesn’t miss payments.

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]

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.

As a rule of thumb, bad economic news brings on lower rates, and good economic news makes mortgage rates climb.

[Mortgage rates vs. stock market]

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.

Read more: What mortgage rate can I expect?