How Mortgage Rates Determined


Current Mortgage Rates (December 2020)

Loan Term

Interest rate

APR

30-year fixed-rate

3.05%

3.28%

15-year fixed-rate

2.91%

3.06%

5/1 adjustable-rate

3.05%

3.25%

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What is the Mortgage Rate?

When you borrow money you will have to pay interest in addition to the principal balance. The mortgage rate, or interest rate, is the rate of interest paid on a loan annually. For a mortgage, the rate is typically between 3%-7%. The rate will be based on the amount of risk the borrower poses. The higher the risk, the higher the rate will be, and vice versa.

For example: If you have a $100,000 loan and the rate is 5%, you will pay approximately $5,000 of interest in the first year of the loan. As the balance decreases, so does the amount of total annual interest owed.

Factors that Determine Mortgage Rates

Interest rates are determined by the amount of risk involved in the loan. If a borrower is considered high risk because they have a low credit score or are not putting much money down then the mortgage rate will be higher. Mortgage rates are determined by these 6 factors.

Credit Score

A borrower’s credit score is the biggest factor determining the mortgage rate on a loan. The higher the credit score is, the lower the rate will be and vice versa. If your score is on the lower side, between 580-620, then you can expect an interest rate on the high side, between 1%-3% higher than the rate a borrower with excellent credit would receive.

Credit Score Ranges

  • 720+ – Excellent
  • 680-719 – Good
  • 640-679 – Fair
  • 580-639 – Poor
  • 579 and lower – Bad

If your credit is on the lower end, you should try to increase your scores as much as possible before applying for a loan. Even just a quarter of a point difference in the mortgage rate can add up to tens of thousands of dollars over the course of a loan.

Please read our article for tips on how to improve your credit score

Debt-to-Income Ratio (DTI)

Your DTI ratio is the amount of your income that goes towards monthly debt payments, such as auto loans and credit cards. The higher the DTI ratio, the risker the loan is; thus, your mortgage rate will be higher. Ideally, lenders want a borrower with a DTI ratio no higher than 36%, but of course, the lower, the better.

Loan-to-Value Ratio (LTV)

The loan-to-value ratio or LTV ratio is the loan amount compared to the purchase price of the home. Your down payment will determine the LTV ratio. The more money you put down, the lower the LTV ratio, the lower the risk.

To get the best interest rates on a mortgage loan, you should have at least a 20% down payment.

Loan Amount

The amount of the loan also comes into play when a lender is calculating the mortgage rate. A large home loan amount presents more risk to a lender, so that the rate will be higher.

Small loan amounts will also have higher rates because of the low loan amount, there is less money to be made, so the lender needs to charge a higher rate to make enough profit on the loan to make sense.

Loan Term

The loan term affects the mortgage rate as well. Short term loans such as a 15-year fixed-rate mortgage will have a lower interest rate than a longer loan term like a 30-year mortgage.

Economy and Bond Yields

Outside of borrower specific factors that change the mortgage rate, the starting point is set by several factors centering around the economy. These include 10-year treasury bond yields and investor sentiment in the secondary mortgage market.

Mortgage rates follow closely to 10-year bond yields, but since a mortgage carries more risk because it is not guaranteed like bonds are, the rate will be higher. When the economy is doing well, investors take money from the bond market into the stock market, pushing bond yields and mortgage rates higher.

The economy, in general, will impact rates; if unemployment rises or the stock market starts to trend downward, then mortgage rates generally follow lower. Anything related to the economy, such as the GDP numbers, inflation, home sales, job growth, unemployment rates, and consumer confidence, can impact rates.

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The Bottom Line…

Mortgage rates are determined by factors outside your control like the economy, Federal funds rates, bond yields, as well as factors you can control such as your credit score, debt-to-income ratio,  and property-specific factors, including credit and debt-to-income ratio.

How Mortgage Rates are Determined

  • Credit score
  • Debt-to-income ratio
  • Down payment (LTV ratio)
  • Loan term
  • Loan amount
  • Economic growth and bond yields
  • Federal Reserve

To ensure you’re getting the best rates available, you should work on improving your credit score before applying and get loan quotes from multiple lenders.

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