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How Are Mortgage Interest Rates Calculated?

How are Mortgage Interest Rates Calculated?

WARNING: This post is best suited for finance geeks and normal people who own a home or are looking to buy and hope to better understand mortgage interest rates. You’ve been forewarned.

As many of you already know, most lenders are in business to make profits. The way they do so is by charging you interest for the privilege of letting you use their money to buy stuff – whether it’s a new pair of shoes, a car, or a home. The amount of interest you pay is determined by the interest rate the lender charges you. The interest rate the lender charges you, in turn, is heavily influenced by two factors: (1) the general interest rate market, and (2) risk-based pricing (your assessed level of risk as a borrower).

The General Interest Rate Market

Mortgage rates are more sensitive to market fluctuations than most other loans. See, these days most mortgage loans are sold on the secondary market and securitized into large pools of loans with similar characteristics. These pools of loans, known as Mortgage Backed Securities (MBS), are bonds sold to investors and whose prices are determined by market conditions. As the prices of MBSs fluctuate in the market, so do mortgage interest rates. And since no investment is analyzed in a vacuum, because investors have choices when it comes to where they invest their money, MBS prices are heavily influenced by the prices of other bonds.

So now let’s take a deeper look into bond pricing…

Bond prices are typically analyzed relative to market benchmarks. These benchmarks tend to be “risk-free” treasuries backed by the U.S. government (and let me tell you, that’s quite some backing). In the case of MBSs, for example, the most commonly-used benchmark is the 10-year Treasury.

However, since the majority of bonds are not risk-free (because no entity out there has the credit reputation of good ‘ole Uncle Sam), there are several premiums used in bond pricing to compensate investors for expected and unexpected risks to which investors in “risk-free” investments are not exposed (or at least not to the same extent). These are:

  1. Inflation Premium: the underlying concept is that your uninvested cash loses its value with every day that passes due to inflation. One dollar today is expected to lose some of its value by tomorrow, and that’s why investors expect to be compensated for the loss of principal caused by inflation (or have you ever heard an investor bragging about just keeping up with inflation?). To make up for that decrease in value due to inflation, investors require a rate of return above and beyond the rate of inflation. Therefore, as the rate of inflation rises, so do market interest rates.
  2. Liquidity Premium: No, this has nothing to do with water. This addresses the ease of converting a particular investment into cash. The quicker and easier it is to sell the bond, the more liquid it is. Liquidity is determined by the market’s supply and demand forces. If your security is highly desirable, such as highly rated corporate bonds or U.S. Treasury bonds, it is considered to be liquid. Conversely, it might be considerably more difficult to find a buyer for a junk bond, making it less liquid.
  3. Default Risk Premium: this is connected to the probability of the debt not being repaid by the borrower. On one end of the risk spectrum, we have U.S. treasuries, which are considered to be virtually risk-free because they are backed by the full faith and credit of the U.S. government. On the other end of the risk spectrum, junk bonds carry a high risk of default. The higher the level of default risk, the higher the investor’s required level of compensation.
  4. Prepayment Risk Premium: this reflects the possibility that an investor may lose future cash flows because a borrower decides to repay the loan (or underlying loan) before the maturity date. In the case of a MBS, for example, an investor’s returns come from your monthly mortgage payment. If you sell your home or refinance the loan, the investor loses the expected cash flow stream associated with your contribution to the MBS pool.
  5. Maturity Risk Premium: this compensates investors for tying up their money for a long period of time, during which they are exposed to interest rate uncertainty and volatility. Bonds with shorter term maturities have a lower maturity risk premium than ones with long term maturities.

Whew! Ok, so to bring it all back, here’s the short answer to how the market affects the interest rates offered by your lender: fluctuating economic conditions affect the bond markets (including MBSs), which in turn affects the interest rates mortgage lenders offer to the public.

Risk-Based Pricing

The concept behind risk-based pricing is that not every borrower is equal in terms of the risk they present to a lender. Some borrowers are riskier than others, and therefore a lender will adjust the pricing of the interest rate it offers to a particular borrower based on the lender’s assessment of that borrower’s risk level.

A borrower’s credit history is the biggest indicator of risk to a lender. As such, your credit score is the most determinative factor influencing the interest rate you pay on your mortgage. It’s very simple: the higher your credit score, the lower your assessed risk level, and therefore the lower your interest rate. We cannot emphasize enough how important it is to keep track of your credit (but more on that topic later).

When it comes to mortgages, there are several other factors that also affect your interest rate and pricing (though not as much as your credit score). Loan-to-Value (LTV) is one of them.

Loan-to-Value is your loan amount divided by the value of the property. If you’re buying a $250,000 home, for example, and you put down $50,000, your resulting loan amount is $200,000, and your LTV, therefore, is 80% (i.e., $200,000 divided by $250,000). To bring it back to the issue of risk, a lower LTV means you have more equity in your home, and therefore present a lower risk of default. As such, the lower your LTV, the lower your interest rate.

Property type also plays a role in determining your interest rate. Condos, for example, can have slightly higher interest rates than other property types. See, when you buy a condo, you’re buying a unit in a building where the rest of the units are owned by other people. The building’s homeowners’ association relies on HOA dues to maintain the building. If you or the other unit owners can’t pay those dues, the property would not be maintained and the value of the building and the individual units could go down. This presents an additional risk to a lender that is reflected in the interest rate.

Another factor that plays into your interest rate is the loan type. A 15-year fixed, for example, because of its shorter maturity, offers a lower interest rate than a 30-year fixed. Adjustable rate mortgages, well, adjust (or fluctuate) based on market conditions. However, they do typically offer lower initial interest rates than fixed rate mortgages, making them great products for some borrowers (see why Adjustable Rate Mortgages are not evil, they’re just not for everyone).

Your intended use of the property also affects your loan’s interest rate. For example, the interest rate you pay to buy an investment property is higher than what you pay to buy a primary home. Buyers are less likely to default on their primary home than on an investment property, therefore making them a lower risk for the lender.

Finally, there are certain factors a lender may NOT use to adjust the interest rate they offer you. These are factors protected by the Equal Credit Opportunity Act (ECOA); they are: race, color, religion, national origin, sex (gender), marital status, age (if the applicant is old enough to enter into a contract), or receipt of income from a public assistance program. Your rate is also unaffected if you’re a first-time home buyer. Adjusting your interest rate based on any of these factors would constitute discrimination, and, as you may know, that’s a big no-no.

Now that everything is, I’m sure, clear as mud as to how mortgage interest rates are determined, let us know if you have any questions or comments. Just kidding, hopefully this was very useful and not too difficult to digest, but please do drop off any questions or comments below!

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