How are Interest Rates Determined? Everything You Need to Know.

If you’re planning on buying a home, you may have found yourself wondering, “how are interest rates determined?”

It’s an important question. After all, your home interest rate can significantly impact your monthly mortgage payment and, as a result, how much you end up paying over the life of the loan as well as whether or not you will be able to qualify for the loan.

It’s only fair that you understand where this all-important percentage comes from.

So, How Are Interest Rates Determined?

To answer this question, let’s plan to keep a few factors in mind:

• The Federal Reserve System, also known as the Fed.
• The 10-year Treasury Yield.
• Your personal finances.

Read on for an in-depth look into each factor below.

The Fed

First things first: note that the Fed does not set mortgage interest rates, directly. This is a common misconception, as the Fed can often influence mortgage rates but does not set them.

We’ll explain more later on but, as we move through this section, just remember that the Fed is not actually setting or changing mortgage interest rates.

What is the Fed?

You may have heard about it on the news or from personal finance professionals, but what exactly is the Fed? The Federal Reserve System is the central bank of the United States. Its role is to help provide the country with a safe and stable financial system. As economic conditions shift, this might mean changing financial circumstances in real-time.

What is the Federal Funds Rate?

One of the Fed’s responsibilities is determining the federal funds rate. This figure is the interest rate that banks pay/receive when they borrow or lend to each other.

It’s an important figure because it can either encourage or discourage financial growth by expanding or contracting the availability of cash. That’s because the impacts of the federal funds rate can trickle down to consumers, through their credit card rates, student loan rates, mortgage loan rates and so on.

Let’s explore exactly how.

Why Does the Federal Funds Rate Go Up?

Sometimes the Fed decides it must raise the federal funds rate. You might hear this decision referred to as “the Fed raising interest rates.” This sometimes happens when the Fed believes the economy may be a bit too hot and needs to be cooled down to try and control inflation.

Essentially, If the Fed raises rates it makes it more expensive for banks to take out loans from one another. Someone needs to pay the difference, so they pass that expense onto you. As such, your credit card rate or mortgage rate could go up.

Why Does the Federal Funds Rate Go Down?

When the federal funds rate goes down, or when you hear about “the Fed lowering interest rates,” it usually means the Fed believes that the economy needs some stimulation. The Fed is basically trying to incentivize consumers to make large purchases and/or take out loans.

In this case, the Fed makes it less expensive for banks to borrow money from each other. They then pass those savings on to you. Your credit card rate or mortgage rate could go down accordingly.

When Might the Fed Decide to Raise or Lower Rates?

The Fed has the ability to change the federal funds rate up to eight times a year. The rate might remain the same, or it might rise or fall depending on the Fed’s perception of the state of the economy.

Here’s a look into the potential change in consumer and Fed behavior that accompanies increases and decreases in the federal funds rate: 

When the federal funds rate is lower, that means that borrowing money is relatively more affordable. As such, more and more people might decide to take out a new credit card or buy a home/refinance an existing home.

When there is high demand for something like homes, however, competition may increase and prices may go up. When prices go up, the nation can experience inflation.

At this point, to protect the economy, the Fed may raise the federal funds rate. This makes it more expensive to borrow money, so people may choose to wait on taking out that home loan or making a large purchase with their credit card.

The Fed and Home Interest Rates

While it may not directly set your mortgage rate, the Fed plays an important role in determining how expensive it may be to borrow money. Keeping an eye on the Fed’s anticipated decisions could help you secure a solid interest rate before the federal funds rate increases and mortgage rates follow suit!

The 10-Year Treasury Yield

Like the Fed, the Department of the Treasury does not directly set mortgage interest rates.

If there’s one thing you take away from this section, let it be the fact that mortgage rates typically follow the 10-year Treasury yield – even more closely than the Federal Funds Rate. When the yield is high, mortgage rates tend to be high too. When the yield dips, mortgage rates tend to fall as well.

So, with this fact in mind, let’s further explore the 10-year Treasury yield.

What is the 10-Year Treasury Yield?

The 10-year Treasury yield refers to the yield, or the amount of income generated, on 10-year bonds issued by the United States Department of the Treasury.

What is a 10-Year Treasury Bond?

You can think of a 10-year Treasury bond as a 10-year loan that investors give the government with the expectation of more profit over time. This is because the government pays interest, also known as a yield, on the bond. This yield is provided in exchange for the privilege of borrowing the investor’s money.

Why Do Investors Buy 10-Year Treasury Bonds?

These bonds are considered very low risk because they’re backed by the US government. The thinking is that the government has enough power and resources to avoid defaulting on the loan.

How Does the 10-Year Treasury Yield Impact Mortgage Rates?

Remember how the federal funds rate affects home interest rates? The 10-year Treasury yield functions similarly.

When the yield goes up, mortgage rates tend to rise as well. This is because investors can buy bonds for less than they may actually be worth, meaning more profit for the investor by the time the bond reaches maturity.

Instead of purchasing a bond at this lower price point, though, investors could instead choose to put their money behind home loans. Investing in mortgage loans may be riskier, but it may provide a higher yield. So, the mortgage interest rate increases as there is more opportunity for investors to profit and higher competition.

When the yield goes down, on the other hand, expect a similar dip in home interest rates. This is because investors are now faced with purchasing 10-year Treasury bonds for more than they may actually be worth. This means there may be a risk that the investor will eventually lose money on the bond.

Investors weigh this potential risk against the risk of putting their money behind home loans. So, mortgage interest rates drop to incentivize investors.

The 10-Year Treasury Yield and Home Interest Rates

Remember, the key takeaway from this section should be the fact that 30-year home loan interest rates coincide with the 10-year Treasury yield. In other words, whether the yield goes up or down, you can expect home interest rates to follow suit.

Keep in mind, though, that the Department of the Treasury is not directly setting or changing these interest rates. Like the Fed, the Treasury yield can just help illustrate financial trends.

Your Personal Finances

Finally, your unique financial situation can also impact your mortgage interest rate. This is great news, as the average borrower can’t exactly control larger economic factors. You may, however, have plenty of control when it comes to your personal finances!

There are a few factors you’ll want to keep in mind when gunning for the best interest rate:

• Your credit score. This number represents your borrowing history. That means it is extremely important to mortgage lenders. Essentially, it can illustrate how safe of a “bet” you are.  Loan programs will likely have minimum credit score requirements and the higher your credit score the better. According to Forbes, candidates with nearly identical applications aside from different credit scores will be offered very different rates. Someone with a score in the 680-699 range would have a mortgage rate approximately 0.399 percentage points higher than a person with a 760-850 score. This means that over 20 years, the borrower with the lower score will pay over $20,000 more in interest on a $244,000 mortgage than the borrower with the higher score.
• Your debt-to-income (DTI) ratio. Your DTI is a comparison of the money you earn and the money you spend on recurring debts each month. To determine yours, add up all recurring debt expenses, including housing costs, car payments, student loans and credit card payments. Then, divide this figure by your gross monthly income. Multiply the resulting decimal by 100 to create your DTI percentage. Borrowers with a DTI above 43% may have a more difficult time getting approved for a mortgage loan. 
• Your loan-to-value (LTV) ratio. The LTV is a comparison of the property’s value and the potential mortgage amount. It is yet another measure of risk, as it wouldn’t be a safe bet for your financial institution to lend out more money than the home is worth. After all, what happens if you default on the loan? Or otherwise need to sell? There is a chance the lender wouldn’t recoup their costs. To determine the LTV, divide the amount borrowed by the property value of the home. While a high LTV won’t necessarily disqualify you, it will mean you pay more over the life of the loan. For example, a borrower with an LTV ratio of 95% could be stuck with an interest rate a full percentage point higher than the rate of a comparable borrower with an LTV ratio of 75%. Lenders will usually offer the lowest possible interest rate to borrowers with an LTV at or below 80%, so this is always a good figure to shoot for.
• Your down payment percentage. The amount you’re willing to pay upfront can either ease the minds of lenders or potentially scare them off. If a borrower opts for a smaller down payment, say, 3%, they have much more to pay off over time. This could lead to financial strain and, potentially, default. If you can put down more, however, say, 25%, the repayment process starts to look a lot less intense. While 20% down is certainly not a hard-and-fast rule, a larger down payment amount makes your home loan less risky. This could lead to more flexibility for more favorable terms, like a lower mortgage interest rate.
• The length of your loan. Ever wonder why 15-year mortgages often come with lower interest rates than their 30-year counterparts? That’s because longer loans are inherently riskier. With a 30-year loan, lenders see double the opportunity for default. Plus, when they do eventually get their money back, it won’t be worth as much, thanks to inflation. You definitely don’t need to discount 30-year loans entirely, especially if that’s what makes sense in your personal financial situation. But, if you can swing a shorter loan term, your pocketbook might eventually thank you.

In short, it isn’t all up to the highest bank in the land! Your personal finances also play a large part in securing you a more favorable home loan interest rate.

How Are Interest Rates Determined: The Basics

Hopefully, you’re walking away with a solid understanding of how interest rates are set. But, if you’re ready to get serious about exploring mortgage loans, make a point to speak with a home finance professional sooner rather than later. They can help comb through your personal finances, identify problem areas and shop around for the best rate and loan program combination possible. Plus, they’ll have personalized, real-time insight on factors like the Fed and the 10-year Treasury yield.

Happy shopping!