How are mortgage interest rates determined?

Mortgage rates fluctuate from day to day, depending on a number of factors related to the economy and to choices made by investors. While some mortgage money comes from deposits held by banks and credit unions, most of the funds for borrowers come from investors in capital markets.

If you are watching mortgage rates so you can lock in a loan at the best time, you will notice that rates tick up and down regularly. Here are a few of the factors that regularly influence mortgage rates:

·     Investor demand. While borrowers are interested in keeping mortgage rates as low as possible, investors prefer high rates so they can get a better return on their investments. But demand depends a lot on other available investment returns and the risk involved with those investments. When investor interest is low, brokerages and banks must increase yields (rates) in order to attract investors to buy these loans and securities.

·     Treasury bonds. Mortgage rates, while not specifically tied to Treasury bond yields, over the long term usually move in the same direction as these yields, with fixed-rate mortgages often tracking the 10-year Treasury bond. Because they are not guaranteed and carry additional risk, rates on mortgages must be a little higher than Treasury bonds to compensate investors.

·     Volume. Sometimes a rush of applications for purchases or refinances will mean there are more mortgages available for investors. An oversupply generally means that mortgage brokerages and bankers will need to raise mortgage rates a little to increase investor interest in buying these investments..

·     Inflation. Rising inflation reduces the actual return on a fixed-interest-rate investment, so when inflation is expected, mortgage rates will also often rise.

·     Federal Reserve. Many people assume that when the Federal Reserve changes the target rate for the Federal Funds rate--the interest rate banks charge each other for loans--mortgage rates will change. In truth, the Federal Funds rate is adjusted according to economic activity and mortgage rates will not always be impacted. Sometimes, in fact, the Federal Funds rate will be lowered in order to stimulate the economy and mortgage rates will actually rise in anticipation of economic growth and possibly higher inflation.

As you can see, mortgage rates are determined by a variety of factors that are not controlled directly by your mortgage lender. However, lenders can help you by anticipating potential changes in mortgage rates.

Michele Lerner contributed to this answer.

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Keith Gumbinger
Keith Gumbinger
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About Keith: Mortgage market observer and analyst with 35 years experience... (more)
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