How Interest Rates Are Determined

With yet another interest rate record broken, you may be wondering just how interest rates are set—or, more importantly, just how your interest rate is set.

Let’s look at the different factors—both large and small—that influence mortgage interest rates:

The Economy and Global Markets. During downturns in the economy, people often move towards conservative investments such as bonds and Treasury notes—which, in turn, affects mortgage interest rates. As the demand for bonds goes up, prices rise and yields fall and mortgage rates trend downward. On a larger scale, foreign markets and global economic conditions indirectly affect interest rates through U.S. markets and the U.S. economy. Reading between the lines, you can see that the lowest interest rates usually occur during the worst economic times.

The Federal Reserve. When you hear the news that the Federal Reserve is cutting or raising the interest rate, that doesn’t mean mortgage interest rates are being cut or raised. It’s a common misconception that mortgage interest rates are directly tied to the federal funds rate, which is the rate set by the Federal Reserve. However, since the Fed lowers the federal funds rate in order to stimulate the economy or raises it with the aim of heading off inflation, mortgage interest rates tend to follow, albeit on more of a long-term scale.

Specific Lenders. Like any business entity, a bank or lender can decide how much it charges for a particular service—and charging interest on a loan certainly falls under the definition of a service. This is why different lenders in different areas of the country have different interest rates. Usually, a lender’s interest rate is based on several factors including the lender’s margins, the competition’s rates and the amount of refinance and new loan business that the lender is currently taking on or forecasting.

Your Credit Rating and Type of Loan. In the end, the biggest and most important influence on interest rates is you. Your credit rating—in conjunction with your home equity and down payment—and the type of loan you get will greatly affect your rate. Borrowers with high credit scores, good home equity and a large down payment are in a great position to get a good rate. Similarly, the type of loan you get—such as a 15-year fixed-rate, which has a lower rate than a 30-year fixed-rate—will affect your rate.

If you want to see what kind of rate you can get, a 10-minute phone call to your broker or lender is a good idea. ∆