Getting a mortgage is a big life event–welcome to the Homeowner’s Club! However, unless you’re paying in cash, you’re going to need to speak with a bank or money lender to get yourself a loan – the big question then becomes what drives mortgage rates?
Having to pay back more money than you borrowed isn’t fun, but there are some key things to know about interest and what impacts it.
So, in this article, we’ll be talking about what drives mortgage rates.
With a few tips and tricks, you can position yourself to get a better loan and keep more money in your pocket–who doesn’t want that?
1. What is a Mortgage Rate?
A mortgage rate is the percentage of interest you have to pay on your home loan.
Borrowing money from a lender isn’t free, and the mortgage rate is part of the price you have to pay.
Here are a few of the costs associated with a mortgage:
The money being borrowed
Interest
Mortgage insurance (not always required)
Loan origination fees
Government taxes and fees
The interest on your home loan is a part of your monthly payment.
For example, if you have an interest rate of 6%, it’s divided over the 12 payments in a year. So, in this case, you would be paying .5% interest on your home loan each month.
You pay interest on your mortgage until it is completely paid off.
That means every year, you will be paying whatever interest rate you signed for.
So, the faster you pay your house off, the less interest you will have to pay.
Mortgage rates fluctuate and vary from lender to lender.
Lender A might give you a 4.5% mortgage rate, while lender B might give you a 6% mortgage rate.
There are a lot of factors that determine the offered rate; we’ll take a closer look at them in the coming sections.
2. What is the difference Between Interest Rate and Mortgage Rate?
A mortgage rate is the interest rate you have to pay on a home loan.
So, there is no difference between an interest rate and a mortgage rate as long as you are talking about borrowed money to pay for a house (or property).
Now, interest rates are much more general than mortgage rates.
Interest rates impact all types of loans: credit cards, business loans, student loans, personal loans, and mortgage loans.
Different loans have different interest rates.
Why?
Collateral!
A loan that is backed by collateral (tangible assets like a home or a car) is considered a secured loan. The bank knows that if the person is unable to pay back the borrowed money, it can repossess the collateral.
That sounds like a bad thing, but secured loans generally have a lower interest rate than unsecured loans.
A personal loan, for example, is an unsecured loan because it’s not backed by collateral.
Banks would be taking on a greater risk of losing money, which causes the interest rates to be higher.
3. What Factors Affect the Mortgage Rate?
Not everyone gets the same mortgage rate.
There is no set interest rate on any type of loan.
What drives mortgage rates is determined by the financial record of the person applying for the loan, the lender’s policies, and the economy.
It can be a bit confusing and frustrating going to different lenders and receiving different mortgage rates.
It’s not a one-plus-one-equals-two situation. So, let’s take a closer look at factors that affect these rates.
Fed rates
When the fed (U.S. Federal Reserve) raises the federal funds rate, the impact will trickle down to the mortgage market.
The federal funds rate corresponds to the interest rate that banks pay when they borrow from each other.
Though mortgage rates actually track the 10-year treasury rate, when banks must pay more to borrow funds, they will pass this on to the consumer in the form of higher interest rates on mortgages and other bank loans.
Economic Growth
The growth of the economy is determined by the Gross Domestic Product (GDP) and employment rates.
When both these factors are going up, it means the people have more purchasing power.
Overall, economic growth is a positive thing, but it also causes an increase in demand for mortgages, which drives the interest rates upward.
When there is less demand, the rates tend to be lower.
Inflation
Inflation is the gradual increase in prices due to things like higher wages and high employment rates.
If it costs more to produce something, or if people have more money to spend, companies can raise prices.
Annual inflation rates greatly determine mortgage rates.
If a lender gives you a mortgage loan with 6% interest, but the annual inflation is 2%, that lender is really getting 4% of the interest.
The higher the annual inflation, the higher the mortgage rate.
Credit Score
Lenders will do a credit check on the person applying for a loan to determine the potential risk.
A better credit score results in a lower mortgage rate.
Lenders usually want to see a credit score of at least 620 – anything under that, and you can expect a high mortgage rate.
If your score is above 700, you’re in a great spot!
Down Payment
Lenders are favorable to those who have a larger down payment.
It shows the lender that you have financial confidence.
If you put $100,000 down on a mortgage and then weren’t able to make payments on the loan, well, you would lose the house and the $100,000 you put down.
So, a bigger down payment means a lower mortgage rate.
Lenders prefer buyers to put 20% down. Anything less than that, and you may have to pay for mortgage insurance.
Loan Term
Mortgage terms are usually set to be paid off in 30 or 15 years (although it can sometimes be shorter).
Shorter terms typically have lower interest rates.
That’s because there’s less of a chance that interest rates will go up (less profit for the lender) or something will happen to the person’s ability to pay the loan.
Lenders see shorter loans as being less risky, which leads to lower mortgage rates.
4. How Do I Get a Good Rate?
To get a good mortgage rate, the best thing you can do is take the time to prepare your finances before jumping in.
What drives mortgage rates is sometimes out of your control–you can’t slow down inflation on your own.
But there are a handful of things you can do, so let’s check them out.
Build up your credit score
The better your credit score, the better your mortgage rate will be.
If you have a low credit score, hold off on applying for a mortgage, and build it back up.
Save up for a big down payment
Mortgage lenders want to see a big down payment (at least 20%).
If you are able to pay that amount, you’ll enjoy a lower mortgage rate.
If it’s under 20%, you may have to pay mortgage insurance.
So, save up for a few years before committing to buying a home.
Take care of other debts
Outstanding debts not only affect your credit score, but lenders also see them as red flags.
Take care of your debts before applying for a loan; it will save you money in the long run.
Wait for the opportune time
Talk to real estate agents and do your own due diligence on economic conditions.
If you are hearing about high inflation rates, it might not be the best time to apply for a mortgage loan.
Watch the forecast and strike at the opportune time.
5. What Type of Loan is Best?
The type of loan you obtain helps drive your mortgage rate.
Mortgage loans come in all shapes and sizes, but we’re going to look at the five most common types and compare them.
Conventional Mortgage
Conventional mortgages are the most common type of loan, making up more than 75% of all mortgages.
They are not backed by the government, which means qualifying is a bit tougher, but the benefits are usually worth it.
Interest rates tend to be lower, your down payment only has to be 5% (in some circumstances 3%), and the loan is backed by Fannie Mae or Freddie Mac (government-sponsored enterprises).
The cons are you need a credit score of 620, and a down payment of less than 20% usually means you have to pay for mortgage insurance.
Fixed-Rate Mortgage
A fixed-rate mortgage means the interest rate of the loan will never change, no matter what happens in the economy.
So, if you sign for a 5% mortgage rate, it will stay at 5% until you pay it off.
This can be beneficial if you’re applying for a mortgage at an opportune time.
If you get stuck with a high interest rate, you’ll pay thousands and thousands of dollars you could have saved.
Adjustable-Rate Mortgage
An adjustable-rate mortgage has an interest rate that changes with the economy.
You will usually sign up for a fixed rate for an introductory period of 5, 7, or 10 years.
After that, your mortgage rate will fluctuate depending on the market.
It can be beneficial if you want to buy a house, but interest rates are currently high.
However, you do run the risk of seeing dramatic increases in your monthly mortgage payments if rates go up.
Jumbo Loans
A jumbo loan (also called a jumbo mortgage) refers to a loan that is too high to be backed by Fannie Mae or Freddie Mac.
Buyers in most parts of the country will have to qualify for a jumbo loan if the amount is higher than $726,000.
The qualifications to be approved for this type of loan are stricter than those for a conventional loan, but the mortgage rates tend to be similar.
Government-Backed Loans
There are three types of government-backed loans: Federal Housing Administration (FHA) Loans, United States Department of Agriculture (USDA) Loans, and Veterans Affairs (VA) Loans.
In general, buyers can qualify for government-backed loans with low credit scores and smaller down payments.
Only people with specific financial circumstances will get approved, and there may be upfront costs to pay for insurance premiums.
6. What is the Lowest Mortgage Rate Ever?
Unless you were born this year, you lived through the lower mortgage rates ever recorded in the United States.
In January 2021, 30-year mortgage rates fell to 2.65%.
If you’re thinking that COVID-19 had something to do with it, well, you’re absolutely right!
When the pandemic halted the economy, the Federal Reserve stepped in to stimulate it, and reducing mortgage rates was part of that plan.
Interest rates slowly declined until they hit a historic low at the beginning of 2021.
Mortgage rates have climbed up since then, but if you were one of the lucky ones who had a secure job and was looking to buy a house, you got a good deal!
But there was a downside to those low mortgage rates.
Housing prices during the pandemic shot up exponentially!
With so many people looking to buy houses with a low mortgage rate, it caused unbelievable bidding wars on run-of-the-mill homes.
Now that the worst of the pandemic is in the past–hopefully–the housing market is getting back to its normal trends.
7. What is the Highest Mortgage Rate in History?
If you are disappointed by your fixed-rate mortgage, let me ease your worries with the highest mortgage rate in history.
In October of 1981, rates for fixed-rate mortgages hit a whopping 18.63% –could you imagine?
Today, you would be paying hundreds and hundreds of thousands of dollars just in interest on average houses.
In fact, unless you paid your house off in just a few years, you would pay more in interest than the amount of money you borrowed–sickening, right?
Interest rates were so high because the Federal Reserve was trying to combat inflation. Essentially the government triggered a manufactured recession to lower prices.
It took about 10 years for the average mortgage rate in the United States to be consistently lower than 10%.
As a piece of advice, if mortgage rates ever hit 18.63% again, rent a home for a few years and save yourself some money!
8. What is a Good Mortgage Rate for 30 Years?
So, now that you know what drives mortgage rates, you may be wondering what a good rate on a 30-year mortgage would be.
It’s hard to compare mortgage rates with the past because the circumstances were different.
The best way to determine if you’re getting a good rate is to look at the averages of the last few years.
If the mortgage rate a lender is offering you is lower than the average, you are likely getting a good rate.
For example, the average rate for a 30-year fixed mortgage in January of 2023 was 6.6%.
That’s 4% higher than rates in 2020 and 2021, and it’s the highest average since 2007.
If your credit score is stellar, your down payment is large, and your loan term is short, you should be able to qualify for a mortgage rate lower than the average.
Speak with real estate agents and lenders to get a feel if the current housing market is the right time for you to buy.
Final Thoughts
When you’re getting ready to apply for a mortgage and buy a house, there are a lot of moving pieces.
The mortgage rate you qualify for can be a huge factor in determining if you can afford to buy a home or not.
I hope this article clarified what drives mortgage rates and how you can position yourself for the best rate possible.
If you read this because you are preparing to buy a home, let me be one of the first to say congratulations!
Becoming a homeowner is an exciting time, and you have a lot to look forward to.
Good luck on your journey!
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Disclaimer: we are not lawyers, accountants or financial advisors and the information in this article is for informational purposes only. This article is based on our own research and experience and we do our best to keep it accurate and up-to-date, but it may contain errors. Please be sure to consult a legal or financial professional before making any investment decisions.
Prior to starting Gokce Capital, Erika received a Bachelor of Architecture from the University of Southern California and a graduate degree in Urban Policy from Columbia University. She worked as both an architectural designer and engineer in New York before joining the New York City Department of Housing Preservation and Development.
Erika currently lives in the New York Metropolitan area with her spouse, daughter and cat. She is originally from Chicago and still considers herself a midwesterner at heart.
Erika also loves to read, write and travel (fun fact, she has visited all 50 states and more than 30 countries!). Her new book, Land Investing Mistakes: 11 True Stories You Need To Know Before Buying Land, is now available on Amazon.