Mortgage Interest Rates: How Are They Determined?

Published on December 19, 2016

– 7 min read

Interest rates are a complicated topic, but very important to understand.

Interest rates are the thing about mortgages that everyone talks about, reports on, and discusses. For good reason! They may affect how much home you can afford and how much you’ll spend over time. So what are they and how are they set?

Interest Rate Basics

An interest rate is an annual fee charged for use of an asset. In this case, the asset is a small pile of money to buy your house. Mortgage interest rates are a very peculiar thing. No one really knows for sure whether they’ll go up or down.

Almost everyone has an opinion on what’s going to happen. Rather than listening to talking heads or reading opinion articles, we want to help you understand what affects the mortgage interest rates.

Where do mortgage interest rates come from?

Contrary to what some people think, mortgage interest rates aren’t set by the government. They respond to the capital markets. While the Federal Reserve can affect interest rates, they do not control them. Mortgage interest rates are more closely related to government bonds, specifically the 10-year Treasury note.

Mortgage interest rates are tied to the bond market. In many cases, when a mortgage company gives you a loan, they package that loan up with a bunch of other loans, and they sell them as an investment. This is called a mortgage-backed security.

Like anything else, mortgage-backed securities respond to supply and demand. If a lot of people are buying mortgage backed securities, the price goes down. If there aren’t many buyers, the price goes up.

This mortgage-backed security has to compete against other investments in the market place. On average, people usually sell their home or refinance their loan within 10 years of purchasing. Because of this, mortgage-backed securities often compete with the 10-year Treasury note interest rate. As a result, the interest rates of two investments tend to move together.

Treasury bills are 100% insured by the government. There is limited risk, and unless the United States government decides to default on its debt, the investor is guaranteed to get their money back.

Mortgage debt is only partially secured by the government agencies (up to 80%), which means there is some additional risk for investors. To account for that increased risk, the interest rates for mortgages are always a bit higher than the Treasury note rate.

Why do mortgage interest rates move?

Also, contrary to what many believe, the mortgage interest rate is not tied to the federal funds rate that is set by the Federal Reserve, at least not directly.

The Federal Reserve (aka the Fed) sets the federal funds rate. This is the rate at which banks lend money to one another. The important thing to know is that a higher rate from the Fed doesn’t necessarily mean mortgage rates will go up.

Take a look at the chart. The 30-year mortgage rate moves generally in the same direction as the federal funds rate, but they don’t move completely in sync.


When the Fed changes rates up or down, it’s more of a signal than anything else. The Fed adjusts the federal funds rate based on key economic indicators like job growth, wage growth, and a host of other signals that point to the strength of the economy.

It’s also a signal about inflation or deflation of the dollar, which is why we care. As inflation goes up, the value of a dollar goes down. Orange juice used to be $1, and now it’s $2 for the same bottle. You can thank inflation for that. (Inflation cannot, however, be blamed for ridiculously expensive cold-pressed juice. That’s different.)

Similarly, a house that was $200,000 in 1990 would cost $362,688.20 in 2015. That’s just inflation alone, not accounting for any property or market factors. The Bureau of Labor Statistics has an interesting (albeit clunky) inflation calculator you can explore. Plug in some dates and a dollar amount, and you can see how the value of that money has changed over time.

The interest rate for the 10-year Treasury notes adjusts with inflation. Because of this, mortgage rates must adjust to stay competitive as an investment.

The important thing to understand is that generally as the 10-year Treasury note rate goes up, mortgage interest rates also go up. As the note rate goes down, mortgage interest rates tend to go down.

Mortgage rates are not directly tied to the federal funds rate, but they can be affected by it. When the Fed manipulates their rate (to affect inflation) it can drive the 10-year Treasury note rate up or down, changing the mortgage interest rates with it.

Mortgage interest rates are indeed a complex topic. If you want to go deeper, see Investopedia and The Balance’s articles.

To see how rates affect your affordability, check out our Home Affordability Calculator and enter different interest rates. If you have more questions about rates, chat with one of our licensed Loan Specialists. To see what rates you might actually be able to qualify for, you can do so in about 3 minutes here.

Andrew Kilburn
Andrew Kilburn is a licensed Loan Specialist at Clara. He likes to live an active lifestyle outside the office, where you’ll find him sailing with his wife and 3-year-old, hiking around the Bay Area, doing yoga, or rock climbing.
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