A mortgage rate is the cost of borrowing money to buy a home. When borrowing money from a lender to purchase a house, you must repay the amount borrowed plus interest, which is calculated using the mortgage interest rate.
A higher rate means it is more expensive to borrow money, and a lower rate means borrowing money is more affordable. This is why borrowers prefer low mortgage interest rates. The lower the rate is, the less you may pay each month in interest expenses. This means a lower monthly mortgage payment and a lower interest expense over the course of the loan.
Are Mortgage Rates and Interest Rates the Same?
“Interest rates” is a broad term that can describe the cost of borrowing money for any loan type. You could, for example, have an interest rate on an auto loan, student loan or personal loan. The term “mortgage rates” specifically refers to the interest rates on home loans.
What Factors Determine Mortgage Rates?
Mortgage rates are based on the perceived risk of lending[1]. The greater the risk to the lender, the higher the mortgage rate to offset that risk. And several factors determine risk, including general economic conditions, specific lender practices, and individual borrower qualifications.
The factors that influence mortgage interest rates include the following.
The Federal Funds Rate, Set by the Federal Reserve
While the Federal Reserve does not directly set mortgage rates, it does set the federal funds rate, which is the target rate for banks borrowing from one another in the short term. This rate changes in response to economic conditions such as inflation or market stagnation.
And many lenders use this rate to determine their prime rates for different loan types, from auto loans to credit cards to home loans.
Your Credit Score
A high credit score indicates that a borrower has used debt responsibly in the past, making payments on time and keeping debt manageable. This means borrowers with higher credit scores may qualify for lower mortgage rates than borrowers with lower credit scores.
The Loan Type
Different mortgage loan types are available to homebuyers and, because of their differing risk levels, mortgage rates can vary by loan type. As one example, the U.S. Department of Veterans Affairs (VA) backs VA loans. Because this makes it less risky for the lender than other mortgage loan types, a VA loan may come with a lower interest rate.
The Loan Amount
A higher loan amount might result in a higher interest rate, particularly if the borrower requires a jumbo loan, in which the loan amount exceeds the maximum loan limits for a conventional loan.
The Down Payment Amount
The greater the down payment amount, the more equity there is in the home. Equity is the buyer's ownership share of a property, as opposed to the share of the property financed by debt. The greater the equity, the lower the risk for the lender. So a higher down payment can lower your rate[3].
The Loan Term
A shorter loan term allows the lender to recoup its investment in the loan more quickly. This reduces the lender’s risk and can result in a lower interest rate than a loan with a longer term[3].
The Mortgage Rate Type
The mortgage rate type can also affect your rate amount. To understand how and why, we need to explore the common types of mortgage rates, which we will do in the next section.
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