How are mortgage interest rates determined?

Mortgage interest rates are the cost of getting a home loan form a lender.

Like every other commodity they are first determined by the product's intrinsic characteristics (risk, rate of return, etc.) and then influenced by external factors (inflation, economy, etc.).

Characteristics of Mortgage Interest Rates

First of all you should know that the basis of all rates offered on financial products (including home loans) is the "risk free" benchmark interest rate (minimum required rate of return acceptable to invest in non-Treasury instruments). As the future is not 100% predictable, to compensate for future risks, investors demand additional returns based on the following:

• Default risk: As always is the case with lending, there is a chance that some loans will not be paid back. This risk is offset when an interest rate is set on a mortgage.
• Liquidity premium: Mortgages cannot be used as instant cash, which means that they are not very liquid assets. This factor is taken into account when setting the interest rate.
• Time: As mortgages contracts typically are 15, 20 or even 30 year contracts, capital is stuck in one investment for a long time. The mortgage interest rates have to be set up in a way to offset this cost.

Based on these characteristics a mortgage's interest rate is determined. Now we will consider the external or market conditions that affect it.

Economic and Market factors

For the most part, the general economic factors outlined below affect mortgage rates in so far as they influence mortgage-related securities. The rates of mortgage-related security (especially those backed by Fannie Mae) are the largest determining factor of mortgage interest rates.

The Fed (or Central Bank):

In the US, the Fed controls money supply and keeps a check on the economy. If it grows too fast, the Fed increases the interest rates which makes borrowing harder, conversely, if the economy is facing a downturn the Fed decreases the interest rates and this boosts the economy. The interest rates set by the Fed in turn affect every financial institution in the country and hence the mortgage interest rates go up and down with the Fed's rates.

Secondary Mortgage Market:

Most mortgage lenders sell their loans in the secondary mortgage market. These loans are considered to be assets and have value. When demand for them is high in the SMM, the mortgage interest rate goes low (so that there are more loans for lenders to sell) and vice versa.

Mortgage Supply and Demand

Generally, a high demand for mortgages tends to increase mortgage rates. Since more people are in the market for mortgages, mortgage lenders can raise mortgage interest rates.

Likewise, when the supply of mortgages outstrips the demand for them, mortgage rates tend to decrease. Since fewer people are looking for a mortgage, mortgage lenders reduce interest rates to attract more borrowers.

Inflation

Mortgage rates generally rise with the prices of goods and services. Property prices rise and so do mortgage interest rates.

Employment Market

A booming employment market means higher mortgage interest rates. More employed people means more people will have money to spend. This means a rising demand for goods and services (including real estate), inflation and thus rising mortgage interest rates.

Individual Factors that Affect Mortgage Interest Rates

General mortgage rates may be determined by the rates of mortgage-backed securities, but your mortgage interest rate is influenced yet again by several individual-level factors.

The following are the factors that a mortgage lender will consider when determining your mortgage interest rate:

• Your credit record
  On top of the list is your credit record.  The higher your credit score and the better your payment history, the better (the lower) your mortgage interest rates are likely to be.
• Your job security
  If you have been in your current position for a significant amount of time, you are deemed to have job security.  People who have job security generally get better (lower) mortgage interest rates than those who often change their jobs.
• Your downpayment
  Generally speaking, the bigger your downpayment is, the lower your mortgage interest rate is likely to be.
• Your acceptance of prepayment penalty rider
  Some mortgage lenders offer low mortgage interest rates in exchange for a prepayment penalty condition.

It is mainly a combination of the above mentioned factors (and then a few more) that determines mortgage interest rates. Keeping an eye on them can help you figure out future trends of the mortgage market.

Why: Know and protect your credit report and score.
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