What Determines Your Mortgage Rate?

Real estate is expensive and most homebuyers rely on mortgage loans to help pay for their homes. If you’re planning to become a homeowner in the near or distant future, it’s important to know what mortgages are, how they work and how to determine mortgage rates.

Mortgages are loans from banks and other financial institutions that have one purpose: to help people purchase homes. In early 2019, the average American mortgage was for $354,500, and in all likelihood, a mortgage will be the largest loan with the longest term that you’ll ever take out.

Considering the size of the investment you’ll be making in a home, it’s important to know basic mortgage terms, how mortgage payments work and what factors impact your mortgage rate before you sign on the dotted line.

What determines your mortgage?

Mortgage loan terms are usually 15 to 30 years in length, which is the duration of time you have to pay back the loan on your home. Before taking out a loan, a potential homebuyer will decide how large of a down payment they can make — an amount that has to be accepted by the lender, too.

A larger down payment can increase the likelihood of getting a mortgage loan approved and will improve your chances of getting a lower interest rate as well. A down payment over 20% will keep you from having to pay for special mortgage insurance and it will reduce your monthly mortgage payments because you’re reducing the amount you owe on your loan. The more you can pay at closing, the less you’ll owe on the principal and interest over the long term.

Still, coming up with a 20% down payment can be difficult if you don’t have ample liquidity. On the other hand, a lower down payment will cost you less at closing, but your monthly mortgage payments will be higher in return.

The two primary components of your mortgage payments are principal and interest. Keep in mind, though, that taxes, homeowner’s insurance and private mortgage insurance (if applicable) may be tacked onto monthly mortgage payments as well.

With each payment, you’re gradually reducing the outstanding principal balance. As a result, you’re building equity in your home. Interest payments, on the other hand, do not increase your equity because they do not pay down the principal.

How to determine your mortgage rate

In addition to the type of loan, term length and features, there are several other factors that determine your mortgage rate, some of which are in your control.

You have control of your credit score, the down payment amount you make and the type of loan you’re looking for, and your credit score — all of which have a direct impact on your mortgage rate.

For example, if you use FICO’s loan savings calculator to look at potential interest rates, you’ll find that rates would range between 3.2% and 4.8% on a $250,000, 30-year fixed mortgage depending on what your credit score is. For example:

FICO ScoreAPRMonthly PaymentTotal Interest Paid
760-8503.21%$1,082$139,614
700-7593.43%$1,113$150,632
680-6993.61%$1,138$159.535
660-6793.82%$1,168$170,438
640-6594.25%$1,230$192,799
620-6394.78%$1,311$222,036

The factors outside of your control are the Federal Reserve, the economy and lender appetite.

The Federal Reserve controls the fed funds rate, which in turn impacts short term interest rates. The Fed does not control mortgage rates, which are long term rates derived from the price of mortgage-backed securities. However, the Fed can influence mortgage rates indirectly through monetary policies, like buying mortgage-backed securities with treasury bonds to keep rates low, or by raising or lowering the federal funds rate.

Outside of monetary policy, other economic principles that affect mortgage rates are home sales, employment rates and GDP. If home sales are up, employment rates are down and GDP is on the rise, that means the economy is growing. Economic growth leads to higher income, which leads to higher consumer spending and more demand for mortgages, as well as higher rates.

Another economic force that impacts mortgage rates is inflation. As inflation rises, the purchasing power of the dollar declines. When purchasing power declines, the value of mortgage-backed securities declines as well, leading to higher mortgage rates.

Rates will also differ based on the lender, as every lender has varying risk appetites, pipelines and overhead costs. For example, if a lender’s pipeline is overbooked with mortgages, it will raise its rates to offset the influx of mortgage applications.

Key factors that determine your mortgage rate

There are multiple factors to keep in mind that will impact your mortgage rate, including:

1. Your credit score

Lenders rely on your credit score to determine if you’ve been responsible with your credit and ideally want to see a proven track record of debt management before extending a loan. In general, consumers with the highest credit scores can get the best interest rates, though other factors, like debt-to-income ratios, can also be factored in.

You should check your credit score before you apply for a mortgage. Most lenders will want to see at least a 620 credit score for a conventional loan, but some special mortgage loan programs — usually the ones that are government-backed — will accept applicants with credit scores as low as 580 in some circumstances.

If your score is below 620, don’t worry. There are several routes you can take to build or repair your credit.

2. Your down payment

The size of your down payment impacts your mortgage rate. It’s less risky for the lenders to work with buyers who have a significant amount of money to put down on a house. A large down payment will lower your loan-to-value ratio, making it easy to meet the underwriting requirements for the loan and reassuring the lender that you have a vested financial interest in the home you are buying.

For example, if you buy a home that has a value of $200,000 and you make a 20% down payment of $40,000, your loan-to-value is 80% ($160,000 loan amount to $200,000 house value).

If you’re unable to make a 20% down payment on a conventional loan, you will likely be required to pay for private mortgage insurance (PMI), which protects the lender if you stop making payments. PMI increases your total mortgage payment each month, but once you pay your balance down to 80% of the home value, you can request your lender remove the PMI.

3. Your loan type

There are multiple types of mortgage loans, including government-backed and conventional mortgages. Government-backed mortgage programs were designed to make it easier for people to get a loan because the credit requirements aren’t as strict and these types of loans don’t require a large down payment. You will be required to pay extra mortgage insurance under these federal programs, though, which can increase the cost of your monthly payments.

Mortgage loans are separated into four categories:

  • Federal Housing Administration loans — These loans are insured by the FHA, which allows down payments as low as 3.5%.
  • United States Department of Agriculture loans — These loans are designed for homeowners in rural areas. If you qualify, you might not owe a down payment and the USDA may back your loan.
  • Veterans Affairs loans — These loans are designed for active military and veterans. Similar to USDA loans, if you or your spouse are (or were) in the military, you could buy a home without a down payment and get a loan backed by the Department of Veterans Affairs.
  • Conventional loans — These are traditional fixed-rate loans that are not backed by the government and down payments can be as low as 3%.

Adjustable-rate mortgages (ARMs) — Unlike fixed-rate mortgages, ARMs have variable interest rates that fluctuate based on market conditions.

The first three categories are considered government-backed loans. For these programs, an approved lender provides the loan while the government guarantees it. In other words, if you fail to pay your loan, the government will repay the lender — thus, reducing the lender’s risk. If you qualify for these non-conventional loans, it’ll be easier to get approved for a mortgage and you might be able to avoid a down payment all together.

4. Fixed vs. adjustable interest

The type of loan you take out will directly affect your interest rate. Fixed interest rates mean you’ll pay the same interest rate over the life of the loan. Adjustable-rate mortgages, on the other hand, offer buyers a fixed rate at the start of the loan but switch to a variable rate after a certain time frame. This often means you’ll pay cheaper rates at the onset but more expensive rates down the road.

5. The loan term

The length of your loan plays a role in the mortgage rate you are offered. Shorter terms often have lower mortgage rates and are cheaper over the life of the loan, though you will have to make higher mortgage payments each month.

When determining the optimal loan term for your needs, keep in mind the amount you can realistically afford to pay each month. A mortgage with a shorter term and lower interest rates isn’t worth the savings if you can’t afford the higher monthly payments.

Tips for saving on your mortgage rate

Shaving a fraction of a percentage off your mortgage rate can save you thousands of dollars, and there are plenty of ways to do that, including:

1. Make a larger down payment

A larger down payment usually means a lower interest rate. If you can afford to make a 20% down payment, you’ll avoid PMI on conventional loans.

2. Pay for mortgage points

If you want to lower your mortgage rate, you can pay for mortgage points at closing. Each point costs a percentage of your loan amount — what percentage will depend on your lender — and you’ll receive lower interest and lower monthly payments in exchange for the higher upfront costs.

For example, if one point is 1% of your total mortgage loan and your loan is $200,000, you would pay $2,000 for each point. You may also be able to purchase a fraction of a point (e.g. 1.25 points would be $2,500).

3. Shop around

Finding the right mortgage for you is no different than the process of buying a car. You need to shop around, check out different lenders and weigh all of your options.

The bottom line

If you’re planning to buy property, you’re probably going to need a loan, which is why it’s important to know the ins and outs of how mortgages work. With a little research, a little education and a lot of shopping around, chances are you’ll be able to figure out what lender and rate work best for your needs.