What Goes Into a Mortgage Rate?
What makes a mortgage rate? What you read on the news are typically the median rate available for the median buyer, but not everyone gets the same rate, why? Let's look at how the sausage gets made
There are four major factors that influence rates:
1) The Cost of Money
Jerome Powell of the Federal Reserve
Federal Funds Rate - the rate that banks borrow money from each other. The Federal Open Market Committee (FOMC- aka the Fed) has a target rate they want to see and they influence by selling gov’t bonds (complicated). Their goal is twofold:
Hit a target inflation rate of 2% (aka price stability), which they can influence (some) by making money cheaper or more expensive to borrow, and
Maximum sustainable employment, which varies over time.
This is the theoretical base level that mortgage rates would ever be, as a bank wouldn’t lend money for cheaper than one could borrow. For years after the Great Recession, this level was set to zero in order to encourage lending and investment, which is one reason mortgage rates were so low before 2022
2) Market Risk Spread
A live look at the mortgage-backed-security market. No, it’s not a tower of Jenga this time.
Guess what, buying mortgages (actually, mortgage-backed securities) carries some risk! Some owners will default, some will sell or refinance and pay you back early. All of those affect how much return can be expected.
What is a mortgage backed security? Loans are bundled together with others of the same terms and sold as a mortgage-backed-security. They sell at higher rates if more risky, lower rates if less risky
Buyers in the securities market have choices and are willing to pay, and mortgage-backed securities are one option compared against others. So what is happening in other parts of the economy affects buyers’ appetite.
The 10-year treasury bill is considered the closest analog to a mortgage as the median mortgage length is about eight years, but carries no risk (unless the US gov’t defaults on its debts 😬). So there is a difference between what buyers in the market will pay for a risk-free 10YT and a mortgage-backed security.
That spread has jumped from the historical 1.5%-2% range to nearly 3% in the last two years. Worries about the economy and inflation, concerns over default risk, etc.. have moved that higher than normal. Confidence in the economy will bring that lower over time, even if the Fed just signals its satisfaction and doesn’t adjust their rates.
3) Individual Risk
I’m smart enough, my credit is good enough and, gosh darnit, banks will like me.
The third factor is you, your specific situation and loan choice. If your credit score is 850, you put 50% down on your house for a fixed-rate conventional mortgage, your loan is the lowest risk, so you’ll be offered the best rate. If your credit score is lower, your loan-to-value is higher, or your loan product not conventional, your loan is considered higher risk, so you’ll pay a higher rate to your mortgage company.
4) Your Lender
Bankers should be required to wear giant bow ties.
If a mortgage lender offers you the exact rate that the market would pay them, they make no dollars, which makes no cents. In order to get paid for their services, a lender will charge either an origination fee (flat fee or % of the loan amount) or discount points ($ used to lower your rate).
How much do they charge? It depends on their size and cost structure. A large bank has lots of overhead, real estate, and layers of management, so their fees need to be higher to cover their costs. A smaller independent mortgage bank *cough cough*, has less overhead and can operate at a lower margin, which means lower cost to the borrower.
Remember that there is ALWAYS a connection between the rate and the fees/points charged, so when a lender quotes a particular rate or monthly payment, you need to understand what they are charging to get that rate in order to compare apples-to-apples with other lenders and choose the best home loan lender.
Side note, have you ever stood in the grocery store and compared apples to other apples? It’s very soothing.