What Determines Mortgage Rates?

Tue Jun 21 2022

Young female mortgage broker explain mortgage rates to a middle-aged couple at home

If you’ve been thinking about buying a home, then rapidly rising interest rates have probably set your teeth on edge. The hikes started in mid-March, when the Federal Reserve approved the first interest rate increase in three years, and have continued into early summer.

Market factors like the Federal Reserve Board certainly impact mortgage interest rates, but they aren’t the only ones that come into play. Here are eight more factors most lenders consider when they determine mortgage rates.

1. Credit Score

Your credit score has a fairly direct impact on your mortgage rate because it tells a lender how consistently you pay off your debts and bills every month. That’s a good indicator of whether or not you’re a good risk to lend money to.

Lenders assume that a higher credit score means you are better at managing your money, and that usually results in a better mortgage interest rate. Most lenders look for credit scores that are at least in the high 600, but there are options for people with low credit scores. For example, Federal Housing Administration (FHA) loan requirements list minimum credit scores in the 500s.

You should also note that your credit score can affect your homeowners insurance rates in some states.

2. Employment and Income

Some lenders take a look at your employment and income to determine your mortgage rate. The key here is consistency. Steady employment and income can lower interest rates because it’s a good sign that you make monthly payments. Lenders want consistency even from those who are self employed.

3. Occupancy

Getting a mortgage on a home you plan to live in usually comes with a lower interest rate than one for an investment property because investment properties carry more risk. A borrower is more likely to walk away from a property they’re renting to others than they are from their own home. This is generally true for second and vacation homes, too, and it usually means higher mortgage rates for these properties than on owner-occupied properties.

Occupancy also impacts your homeowners insurance. For an investment property, you may need landlord insurance, but a vacation home could require second home insurance.

4. Loan Amount

Jumbo loans, or also called nonconforming conventional mortgages, can have higher interest rates. This is partially due to the risk. Neither Freddie Mac nor Fannie Mae can guarantee a jumbo loan, leaving the lender unprotected if the borrower defaults. With some exceptions, the current maximum amount for a conforming loan is $647,200 for most of the US. Jumbo loans exceed that amount.

On the other hand, mortgages that are for a very low amount don’t earn much in terms of interest. Lenders sometimes charge additional fees on smaller loans to cover their costs and turn a profit.

5. Down Payment

A down payment shows your lender that you have skin in the game. As a result, your lender may charge a lower interest rate for a larger down payment, assuming that signals you’re more committed to owning and maintaining the property. Some homebuyers even pay points to bring down their loans and get better mortgage rates.

6. Loan Duration

Loans with a longer duration, or loan term, mean the lender takes on more risk, so it usually increases the mortgage rate. For example, a 30-year fixed-rate loan typically has a higher interest rate than a 15-year fixed-rate loan for the same amount.

Keep in mind that the loan with the shorter term may have higher monthly payments. The benefit, however, is that you end up paying the principal down faster.

7. Interest Rate Type

There are two types of mortgage interest rates: fixed and adjustable. In a fixed-rate mortgage, the interest payment stays the same for the entire term. An adjustable-rate mortgage (ARM), however, changes with the market. ARMs often start with a low introductory rate, but that may increase over time.

If you decide on an ARM, you want to look closely at the terms of your loan. The low mortgage rate may seem like a way to save money, but it can quickly become more expensive than a fix-rate loan. Learn more about this in our article “How Does Mortgage Interest Work?”

8. Loan Type

Homebuyers can choose from several types of loans, including conventional loans and loans backed by the FHA, the US Department of Agriculture, and the US Department of Veteran Affairs. Each comes with its own eligibility criteria and interest rates. Lenders can compare the rates of different loans for you if you are eligible for more than one type.

For more help on mortgage, take a look at our article “Mortgages Explained: A First-Time Buyer’s Guide.”