The Fed Keeps Raising Rates. But That’s Only One of Many Factors Driving Rising Mortgage Rates

A photo to accompany a story about how mortgage rates are determined Win McNamee/Getty Images
Federal Reserve Chairman Jerome Powell speaks at a news conference following a Federal Open Market Committee meeting on May 04, 2022 in Washington, DC. Powell announced the Federal Reserve is raising interest rates by a half-percentage point to combat record high inflation.
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The cost of just about everything is going up these days — and if you’re in the market for a house, you probably noticed that includes mortgage rates, too.

Mortgage rates are averaging around 5.9% nationwide, and they’re likely to go up again. That’s because the U.S. Federal Reserve issued its largest rate hike in nearly 30 years as it tries to combat inflation. 

The Fed’s base rate, however, isn’t the only thing that will determine your mortgage rate. It has an impact, but so do plenty of other factors — like the overall state of the economy, or the type of mortgage — as well as your personal financial profile.

Here’s everything you need to know about how mortgage rates are determined, and how that will impact your home purchase.

Factors That Affect Mortgage Rates

Most of the factors that affect mortgage rates are out of your control: there are larger forces at work in the economy and in the country’s biggest financial markets. There are some factors in your control — like credit score, or loan-to-value ratios — and we’ll get to those later. But first, it’s important to understand the bigger forces at work.

The Federal Reserve and the Prime Rate

This is the one you’re probably hearing a lot about lately. That’s for two reasons: One, because the prime rate is going up. And two, because it’s one of the more important factors behind mortgage rates.

“The federal reserve controls the prime rate, and the prime rate is basically the rate that banks borrow from one another. And as the cost of funds increases and they raise rates, rates that the consumer is going to get will be subsequently higher,” said Mayer Dallal, managing director at digital mortgage lender MBANC.

In essence, there’s a cost to the money that banks are borrowing in the first place, and they then need to make a profit when they lend the money to a homebuyer. So as the Fed raises the prime rate, the banks will raise the mortgage rates to keep their profit margin intact.

The Bond Market 

A bond is a type of loan — usually used by companies and governments — with a strict timeline for repayment to its maturity. Historically, the bond market has been pretty stable and predictable. But with inflation rising, the long-term value of mortgage bonds is going down, Dallal said.

That has an impact on mortgage rates, because they usually do the opposite of what the bond market is doing. So with bond prices falling, mortgage rates are rising.

Mortgage Backed Securities 

Mortgage backed security, or MBS, is similar to bonds. But unlike a traditional bond, the payments back to investors come from all the mortgages that underlie the bond. An example of this would be institutions such as Fannie Mae or Freddie Mac, who buy loans from lenders and structure them to pay interest like a bond, but into a mortgage-backed security.

Mortgage lenders generally increase interest rates when the prices of mortgage-backed securities drop. And lenders lower interest rates when the price of MBSs increase. 

Inflation 

The relationship between inflation and mortgage rates is pretty straightforward: As the cost of goods and services increases, mortgage rates will jump to keep up. Plus, institutions like the Federal Reserve have an interest in cooling inflation, and they’ll often raise interest rates in an effort to slow the economy down (without tipping it into a recession, ideally).

 “As costs of things go higher, the only way to really curb inflation is to raise rates,” Dallal said.

State of the Overall Economy

It’s hard to describe the overall state of the economy when you’re talking about a country as large and varied as the U.S. But the general sense of how the American economy is doing does ultimately impact interest rates.

For example: During the early days of the COVID-19 pandemic, the economy for Americans was almost universally bad. As a result, interest rates stayed low to incentivize people to borrow and spend money, despite the rough market conditions. Now it’s the opposite: The economy (and housing market) is overheating, and interest rates have increased to try to cool things down.

Secured Overnight Finance Rates (SOFR)

This is another way that banks lend money to each other, but specifically refers to borrowing cash overnight. The SOFR had been consistently low throughout the pandemic, but starting in April has risen significantly. 

Just like the prime rate, this is a baseline factor that impacts the bottom line for banks, and ultimately the mortgage rates they can offer. “As their cost of funds increase, it gets passed along,” Dallal said.

The Constant Maturity Treasury Rate

The Constant Maturity Treasury Rate is a daily measurement of Treasury security yields, and it’s seen as a predictor of future funding costs (again, the cost for banks to acquire funds in the first place). It’s an important indicator for lenders, who often use it to determine the annual rates that influence the variable rate on adjustable-rate mortgages (ARM loans)

Type of Mortgage

At the end of the day, mortgage rates are all about risk. Banks use mortgage rates to generate a profit, but also to cover themselves in the event that a borrower defaults on the loan.

Because different types of mortgages carry different levels of risk, mortgage rates will vary accordingly. A mortgage for a single family home, for example, is usually lower than a mortgage for a multi-family property. A mortgage with a shorter term, like 15 years, is also less risky, and would likely have a lower interest rate than a 30-year mortgage.

“If it’s a shorter period of time, you’re going to get a better rate,” said Meghan Jones-Rolla, chief legal officer and chief operating officer at Mortgage Connect, a mortgage servicing company.

What Affects My Personal Mortgage Interest Rates?

When you combine all of the macro-economic factors, you will end up with a standard interest rate that a bank promotes on its website. But that’s not necessarily the interest rate you’ll end up with. It can increase (or decrease) based on your financial situation, and specifics of your mortgage.

Pro Tip

The mortgage rate that a bank advertises online might not be what you end up with. Talk to a lender to understand what type of rate you qualify for.

Loan-to-Value Ratio

In the simplest terms, loan-to-value ratio, or LTV, is the relationship between how much a home is worth and the size of the mortgage. For example, if you have a 20% down payment, that means your mortgage covers 80% of the home value, and your LTV is 80%.

This impacts mortgage rates because a higher LTV is considered “riskier” to a bank — you have less equity in your home, and there’s a greater risk that the bank will lose money if you default on your loan. Banks and lenders compensate for this by increasing mortgage rates when the LTV is higher.

“The higher the loan-to-value, the higher the rate, and that’s purely based on a risk assessment,” Dallal said.

Personal Credit Profile

When a bank is giving you a mortgage, they want to be sure that you can reliably make the payments. If you have a strong credit profile and score, that gives a bank more confidence. As a result, lenders will usually be willing to offer you a lower interest rate if you have a strong credit profile.

“Even more now than ever, credit is just so important,” Dallal said.

Down Payment

This ties back into the concept of loan-to-value ratio. If you put down a larger down payment, that means your loan will cover a smaller percentage of the home value. In effect, that means it’s less risky for a bank to offer the loan, and they might offer a lower interest rate as a result.

On the flip side, a smaller down payment will be seen as riskier, and a lender might raise the interest rate accordingly to compensate. Typically, a down payment less than 20% would lead to needing private mortgage insurance for the same reason. 

Can I Get a Rate Lower Than the National Average Mortgage Rate?

When you read about mortgage rates going up, you’re often reading about the national average mortgage rate. That’s a number determined by weekly rate information that lenders provide to the public, and represents the “typical” mortgage rate when you average out all the variations.

Many homebuyers wonder if they can undercut this rate to get a better deal on their mortgage. Experts say that it’s possible, but it depends on a few factors. 

First, you’ll need a stellar credit profile if you think you’re going to get a lower-than-average interest rate. Second, it depends on the specific lending services; some lenders, when they’re looking to grow their mortgage portfolio, will offer artificially low interest rates just to increase volume, Dallal says. And third, you might be able to get a lower rate if you consider discount points or mortgage points, which are an extra fee that you pay upfront when you purchase a home in exchange for a lower interest rate over the life of your mortgage. 

Dallal cautions, however, that a lower rate is not always better. There are other factors to consider when choosing a lender. You want to make sure you’re working with someone you trust that can get your home purchase closed in a timely manner.

“The best rate doesn’t always equate to the best circumstance,” Dallal said. It’s just as important to pay attention to closing costs as it is the rate. Closing costs are the additional fees that make up the cost of borrowing. Some lenders offer a higher interest rate in exchange for lender credits. When comparing loan offers, don’t count out all candidates based on rate alone. Ask about all the fees of borrowing.