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When you’re shopping around for a loan, the interest rate you’re given is one your most important considerations. After all, it has a big impact on how much you’ll be expected to pay each month. You probably know that it’s in your best interest to get a loan while mortgage interest rates are low, but have you ever wondered how these rates work?
If so, keep reading. In the post below, I’ll cover how mortgage interest rates are determined, as well as why each person can receive a different rate.
How mortgage interest rates are determined
Secondary markets
Believe it or not, once your lender gives you your mortgage, they don’t keep your debt in-house. If they did, they’d have to wait a long time for their investment to pay off. Instead, they sell your debt to third-parties known as mortgage aggregators.
The aggregators – like Fannie Mae and Freddie Mac – then take your mortgage debt, bundle it with other debts, and repackage it into what’s known as mortgage-backed securities.
Those mortgage-backed securities are then broken down into shares, which are sold to individual investors, who hope for a return on their investment.
In this case, mortgage interest rates are determined by two things: the price at which your debt is sold to the aggregators and the price at which the investors are willing to buy their shares. It’s a supply-and-demand scenario that’s affected by a mix of economic factors.
The economic factors
Multiple economic factors go into the prices at which mortgage-backed securities are bought and sold. One important one is the Federal funds rate, or the rate at which banks are allowed to borrow money. In weak economies the Fed lowers this rate to encourage people to keep borrowing. In strong economies, the Fed raises the rate to stave off inflation. For their part, the lender must charge enough to cover the cost of borrowing the money.
The rate of inflation also plays a role. Inflation is the phenomenon which occurs when the price of goods and services rise across the board. Inflation poses a problem for investors because it means that the money people borrow now will be worth less when they pay it back and when the investors see their returns. When a rise in inflation is predicted, investors are less eager to buy into mortgage-backed securities because their returns will be lower.
How you’re given your interest rate
All of those factors listed above play into what interest rates are available on the market. But the truth is the rate you’re given could be very different.
Again, the rate you’re given is going to be based on multiple factors. They may include:
- Your credit score
- If you’ve had any bankruptcies or other financial events
- Your income and employment history
- Your debts
- Your cash reserves and assets
- The size of your down payment
- Your loan type, term and amount
In general, the bigger the risk the lender sees in approving you for a mortgage, the higher your interest rate will be. However, keep in mind, different lenders may offer you different rates, which is why it’s important to shop around for a loan.