Where Do Rates Come From?

Just where do mortgage rates come from?

Do banks and brokerages all have a fortune-teller hidden in a back room? Maybe they shake a really complicated-looking magic eight-ball?

It turns out there’s a method to the madness of all the interest rates floating around out there. Like many mortgage lending things, it’s complicated though. So, let’s take a basic tour of how rates come to be.

Interest Rate or APR?

First up, let’s talk about some of the numbers you’ll see and how to know what’s actually an interest rate and what’s not.

Mortgage interest rates come in eighths of a point. That means the interest rates between three and four percent should look like this:

  • 3%
  • 3.125%
  • 3.25%
  • 3.375%
  • 3.5%
  • 3.625%
  • 3.875%
  • 4%
That’s it. All rates should follow this formula of moving up or down by 0.125 percentage points.

Now, you’re probably thinking about that time you saw ads for 3.36% and 3.99%. Those don’t follow the pattern. And wasn’t there a national survey report recently that said rates had hit a high of 4.09%?

In the case of the loan ads, what you’re seeing is the lender’s annual percentage rate (APR). That’s your interest rate with discount points, closing costs, origination fees, and other costs also factored in. For the survey, you’re looking at an average of the thousands of rates offered to thousands of borrowers.

Stocks, Bonds, and Securities, Oh My

This is the part where things gets complicated — more complicated than can be explained with pithy one-liners — but here’s the upshot.

There’s a type of government bond called the 10-year Treasury bond. When stock market investors are looking for a safe, medium-term investment, they might buy these.

Fixed-rate, 30-year mortgages are often packaged up and sold on to a secondary market as mortgage-backed securities (MBS). The same investors might also buy these.

Even though the mortgages are 30-year loans, the average loan gets paid off (when a home is re-sold) or refinanced within about 10 years. That makes these bonds and mortgage-backed securities similar financial products that compete in the same market.

Because of this similarity and because there’s a strong correlation between 10-year Treasury bond yields and mortgage interest rates, experts monitor both.

Got that? Cool. So, what makes bond prices and interest rates go up or down, then?

It’s the Economy, Man

Turns out the economy has a pretty sizable impact on both bonds and mortgages rates. Reports on home sales, employment, consumer confidence, and more, give insight into the health of the economy and can easily send rates up or down depending on the news.

When the economy isn’t doing so hot, investors tend to sell their stocks and look for safer investments, like 10-year Treasury bonds. When these bonds get bought up, their prices may go up but their yield (think investment return) goes south. Yield down? Mortgage rates down.

When the economy starts to take off, investors know they can make more money in stocks, so they forget about bonds for a minute, which makes prices go down and yields go up. Yield up? Mortgage rates up.

Other Forces That Influence Your Rate

Of course, there are a number of other factors that heavily influence your interest rate, as well. Supply and demand, timing, and pricing adjustments can all have a big impact.

The key to remember is that mortgage rates are closely linked to a number of other parts of the economy. If economic data starts shifting, you can bet interest rates aren’t far behind.