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 broker to secure their interest rate, often without researching 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 interest rates move, and why. After all, a change in rate of a mere .125% to .25% could mean thousands of dollars in savings 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 is said to be the best indicator to determine whether mortgage rates will rise or fall. But why?

Because most mortgages are packaged as 30 year products, and the average mortgage is paid off or refinanced within 10 years, the 10-year bond is a great bellwether to measure interest rate change. Treasury obligations are also backed by the “full faith and credit” of the United States, making them the benchmark for many other bonds as well.

10 year Treasury bonds, also known as Intermediate Term Bonds, and long-term mortgages, known as Mortgage-Backed Securities (MBS) also 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.


So 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.

To get an idea of where mortgage rates will be, bond investors typically use a spread of about 170 basis points, or 1.7% above the bond yield to estimate interest rates. So a bond yield of 4.00 plus the 170 basis points would put interest rates around 5.70%. Of course this spread can vary over time, and is really just a quick way to ballpark mortgage interest rates.

There have been, and will be periods of time where mortgage rates rise faster than the bond, and vice versa. So just because the 10 year bond rises 20 basis points doesn’t mean mortgage-backed securities will do the same. In fact, MBS could rise 25 basis points, or just 10 points, depending on other market factors.


What other factors move interest rates?

Factors such as supply come to mind. If loan originations skyrocket in a given period of time, the supply of mortgage-backed securities will rise beyond the demand, and prices will need to drop to become attractive to buyers.

Timing is also an issue. Though bond prices may plummet in the morning, and then rise by the afternoon, mortgage rates may remain unchanged. That’s because sometimes the bond movement doesn’t always make it down to the wholesale markets, or simply because it takes more time to do so.

Inflation also greatly impacts mortgage rates. If inflation fears are strong, interest rates will rise, but in times when there is little risk of inflation, mortgage interest rates will most likely fall.


Economic activity will impact mortgage interest rates.

Mortgage rates are more susceptible to economic activity than treasuries, mainly because the average consumer or homeowner may lose their job or 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 interest rates significantly.

And don’t forget the Fed. When they release “Fed Minutes” or change the Federal Funds Rate, interest rates can swing up or down depending on what their report indicates about the economy. Generally, a growing economy leads to higher interest rates and a slowing economy leads to lower interest rates.

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

The situation is a lot more complicated, so consider this is an introductory lesson on a very complex subject. And remember, these base rates don’t take into account any pricing adjustments or fees that could drive your actual interest up or down.