What Factors Affect Mortgage Rates

By Noah - February 16, 2022

If you’re looking to purchase or refinance a home, mortgage interest rates can be an important part of the equation. Especially for refinancing, mortgage rates can make or break whether it’s worth it to move forward with a new financing plan.

Generally, you can move forward on important home goals (such as purchasing a home) without knowing the nitty-gritty about why mortgage rates change. But some homeowners may be interested in why mortgage rates fluctuate — either to help understand when refinancing might be a good idea, or just out of old-fashioned nerdy interest (#nojudgment). Get a peek behind the curtain at how the economy and mortgage rates intertwine.

Who Sets Mortgage Rates?

When you take out a mortgage loan through a lender like a bank or other financial institution, this agreement sets off a chain of events. Say you purchase a $400,000 home with a 20% down payment ($80,000). The lender pays the remaining $320,000 so the sale can go through, and you gradually repay the loan over 30 years (or however long the term of your mortgage loan is).

The problem for the lender is that even a bank doesn’t have unlimited liquid funds on hand, and mortgages take a long time to pay off. Banks that want to extend mortgages to hundreds of people need a way to replenish their cash flow. The solution is to sell mortgages at a profit into a secondary market. That usually means selling the mortgage to Fannie Mae or Freddie Mac. Both of these major financial institutions bundle mortgages into securities, which they can sell in turn to investors.

The idea is that this should be a win-win-win-win situation. You get to move into your house without paying the whole price upfront. The bank recoups cash quickly so they’re ready to serve the next customer. Fannie and Freddie get to offer enticing securities. And investors get to put money into mortgage-backed securities (MBS), which are generally considered low-risk investments.

So ultimately, the investors on the secondary market are a major force in driving mortgage rates. If yields are too low and investors stop buying MBS, lenders need to raise interest rates to convince investors to buy in. When demand for MBS is high, interest rates tend to drop on the homeowner end of the chain.

What Impacts Mortgage Rates?

Broader trends in the economy and mortgage rates have a relationship because of this chain that connects homeowners not only to lenders but ultimately to investors who buy shares in MBS. Understanding more about economic factors overall can help you gain some extra insight into what drives mortgage rates up and down.

Inflation

Inflation measures how the purchasing power of currency declines over time as the prices for goods and services in the economy rise. It’s not necessarily a bad thing for the economy overall, but it does mean a dollar won’t stretch as far as it once did over time.

Lenders think about inflation when they set mortgage rates. They need to maintain mortgage rates that are high enough to make up for the impact of inflation and secure a net profit on top of that.

Economic growth rate

A thriving economy can tend to drive mortgage rates up. Think about those secondary market investors — when the economy and stock market are doing great, investors are more drawn to investments that hold a higher yield, so interest rates go up accordingly to keep an MBS attractive. An economic boom can also mean more people are in a good financial position to buy a home, so there’s more demand on the bank side for mortgages. Lenders only have the capital for so many new mortgages at a time, so raising mortgage rates can give them a little extra profit and help keep their pool of new mortgage applicants manageable.

When the economy slows down, the reverse happens. Investors flock in greater numbers to “safer” investments like bonds and MBS, so rates can come down. The pool of people applying for new mortgages dries up because more people are tightening their belts. Lowering mortgage rates at that time can help bring in some homebuyers or convince other homeowners to move forward with a refinance.

Housing market

Trends in the real estate market can also impact mortgage rates. Typically, what you might expect to happen is that if the housing supply is fairly low, meaning there are not many sales and new mortgages going through, interest rates also stay low (so banks have the best chance of bringing in the mortgage supply they can).

The time we’re living in right now is anything but typical, of course. The coronavirus pandemic led to a large economic slump as millions of people lost their jobs or saw major cutbacks on wages or hours. Inventory of houses for sale has been extremely low (people who have homes to stay in for quarantine may not be eager to sell!). Both of these are signs that we’d expect to see interest rates bottoming out, too — and they have.

But rather than perhaps waiting for more homes to appear on the market, people have skyrocketed demand for homes, resulting in wild bidding wars for the houses that do become available, as well as high demand for new construction of homes. Construction slowed down in 2020 along with most other industries, meaning that even now, there are supply and labor bottlenecks keeping builders from meeting homebuyer demand. Low housing supply should keep mortgage rates low, but the improving economy and powerful demand mean we should see rates climb again. So which factor wins?

At this point, it’s looking like we can expect mortgage rates to follow a gradual increase through the end of 2022, but it’s likely to be slow. As of August 11, 2021, the average 30-year mortgage interest was around 3.11%, and some experts predict average rates will reach 3.4% or 3.5% by December 2021, and 3.8% or so by December 2022. This slow creep makes sense because there are some factors at play that would typically drive mortgage interest up, and others that would keep it down. 

In other words, if you have been interested in a mortgage refinance, you don’t need to race to the bank, but don’t put it off too long, either. The refinancing rule of thumb says this move makes sense if you can get a new fixed mortgage rate at least 1% lower than your current rate. Depending on your current mortgage rate, the predicted rate increase could affect whether a refinance would still be worth it if you put it off for a year.

Should You Worry About a Housing Bubble?

One piece of good news for homeowners and homebuyers is that it’s reasonable to think of the current market as a housing boom, not a bubble likely to lead to a crash like in the 2008 financial crisis. The Great Recession housing bubble burst because too many lenders extended mortgage loans to subprime borrowers. When it turned out homeowners couldn’t keep up with the mortgages, the wave of mortgage loans turned into a wave of foreclosures. Those foreclosures impacted the rest of the mortgage-to-secondary-market chain, devaluing investments and contributing to a major financial collapse.

The current market is so competitive in part because of the way the pandemic restricted the construction industry, lowering supply. It also restructured the way many people live and work (i.e., more widespread, long-term, work-from-home arrangements), leading to a higher demand for homes that can accommodate home offices, for example. In short, there are reasonable factors to explain why home values are rising but there’s still strong demand, and it seems likely that we may see high home value and high demand well into 2022.

If you’re interested in buying a house but not sure how to find the right fit in today’s market, we’ve got tips for saving a down payment and avoiding PMI, and you can reserve your spot to be the first to hear about new down payment financing options.