A good mortgage rate is relative.
Years ago, a favorable interest rate for a 30-year fixed mortgage was around 7 percent. Fast forward a few years later and anything over 5 percent was considered extremely high.
So what determines the mortgage rate you will pay when you buy a home? Mostly, your rate will be determined by:
- Economic influences.
- The type of mortgage you obtain.
- Your financial status at the time of application.
The biggest influence on mortgage rates are factors beyond your, and even your lender’s, control.
One common misconception is that mortgage rates are set by the Federal Reserve. The Federal Reserve sets what is known as the federal funds rate, which is what it charges banks for short-term loans.
The federal funds rate can influence the movement of mortgage rates, especially adjustable rate mortgages (ARMs), but they are not directly related.
Mortgage rates are determined in large part by a secondary market of investors.
Rather than having money tied up for several years, lenders typically sell mortgages to investors who want a regular stream of income.
As a hypothetical example, say a bank loans you $100,000 to buy a home. Based on your interest rate, the principal and interest payment will total an estimated $150,000 over the life of the loan.
The lender can sell that mortgage to investors for, say, $125,000. That means the lender gets the original amount of the loan back plus an extra $25,000 profit. It also has $125,000 in capital which it can use to make another mortgage loan. The investors group will also turn a $25,000 profit ($150,000 in payments - the $125,000 spent to purchase the loan).
Mortgage lenders offer homebuyers an interest rate that investors are willing to buy while still ensuring they turn a profit.
Individual investors don't purchase a whole mortgage, however. They buy pools of similar mortgages called mortgage-backed securities (MBS). An MBS is similar to how a mutual fund is a pool of different stocks.
Like with other types of investments, the price of MBS rises and falls continuously based on demand. When MBS prices drop, lenders raise interest rates. When prices increase, mortgage rates will fall.
So what causes movements in MBS prices? Like with bonds, MBS prices are based on yield, which is the relationship between MBS price and the interest it pays.
In general, if the economy is good or showing signs of growth, investors want higher returns. Therefore, they don’t want to settle for small returns that they get from safe investments like an MBS. Lower demand for mortgages, therefore, will cause MBS prices to fall, which will lead to an increase in mortgage rates.
Economic signs of higher mortgage rates include:
- Gains in the stock market.
- Increasing consumer confidence.
- Higher economic activity.
- Low unemployment.
On the other hand, signs of a slowing economy or economic uncertainty will lead investors to move money into safer, lower-risk investments like mortgages. The higher demand for mortgages will push MBS values higher, leading to lower mortgage rates to homebuyers. This is why, in the years following the 2008 financial crisis, mortgage rates dropped to historically low levels.
Mortgage rates tend to move in roughly the same pattern as Treasury yields. Mortgage rates typically remain higher than Treasury yields because MBS are a riskier investment. Thus, as Treasuries rise or fall, so do mortgage rates.
The length and type of mortgage you seek to obtain will also greatly influence your interest rate.
The longer your rate is fixed for, the more risk the loan poses to the lender. Therefore, the higher your interest rate will be. That’s why 30-year fixed rates are several basis points higher than 15-year fixed mortgages.
Your initial rate will also typically be lower if you opt for an adjustable rate mortgage.
Also known as an ARM, this type of mortgage establishes an interest rate that will adjust over time. The rate will stay fixed for the first three to 10 years, depending on the term selected. After that initial term expires, the rate will adjust regularly based on certain economic factors. The main advantage of an ARM is that the initial rate will likely be lower than what you can get on either a conventional loan or a doctor loan. However, the rate you pay will rise after that period will expire.
Many financial institutions also offer physician mortgage loans specifically to health care professionals. Banks offering this type of financing can offer relaxed underwriting guidelines and waive some of the requirements of conventional loans. However, to mitigate some of the added risk of relaxed underwriting, physician mortgages often come with higher interest rates than conventional loans.
Your financial status also helps determine your mortgage rate.
Similar to how insurance companies charge premium based on the risk of the insured, so too do mortgage lenders set individual interest rates based on the risk of a borrower defaulting.
Lenders underwrite potential borrowers. Factors that may influence the interest rate you pay include:
Income. Lenders look at past and present income to predict a borrower’s ability to make their monthly payments. Physicians are considered low risk because of their high income and relative job security when compared with other professions.
Your current debt. Mortgage lenders underwrite you based on your debt as a percentage of your income, which is known as your debt-to-income (DTI) ratio. The lower your DTI when you apply for your mortgage, the better your chances of making your mortgage payment. This means less risk to the lender and a lower interest rate for you. An advantage for health care professionals is that physician mortgages often remove or recalculate student loan debt when determining your DTI ratio.
Credit score. Your credit score is a measure of how well you’ve handled debt and credit in the past. The higher your credit score, the less risk you pose to a mortgage lender and the lower your interest rate.
Downpayment. In general, the higher your downpayment, the lower your interest rate. That’s because lenders consider a higher downpayment less risky because the borrower has more stake in the property.
If you liked this article, then you'll probably love:
The Ultimate Guide to Physician Mortgage Loans in 2021
Joel Palmer is a writer and personal finance expert who focuses on the mortgage, insurance, financial services, and technology industries. He spent the first 10 years of his career as a business and financial reporter.