How do lenders assign interest rates on home loans?

Stop me if this sounds familiar. You see a certain interest rate for a home loan advertised on the mortgage lender’s website. It’s a fairly low rate, so you figure you’ll apply for a loan with this particular lender. You call them up, you fill out all of the necessary paperwork, and you receive an offer with an interest rate and other terms. But the rate they have assigned to you is more than a point higher than the one advertised on the website. How is this possible?

This brings us to one of the most common questions among first-time home buyers. How do lenders assign interest rates on home loans? And that’s what we are going to discuss in today’s lesson.

Where Do the Average Mortgage Rates Come from?

Lenders assign interest rates based on a variety of factors. All of these factors fall into one of two categories. They are either related to market conditions or the individual borrower. Market factors will determine the average rates being offered at a given time. Personal qualification factors will determine the rates offered to a specific borrower for a particular home loan.

This is an important distinction that many first-time home buyers fail to understand. You have the average rates for home loans, which are determined by market activity and economic factors. This is the rate you might see advertised on the lender’s website. But you also have the home loan rates assigned to individual borrowers. These are influenced more by the borrower’s qualifications (credit score, debt ratios, down payment, etc.).

Let’s look at some of the key factors that determine the average mortgage rates at any given time. After that, we will discuss the factors the lender will use to assign a rate for your home loan.

Some of the things that move mortgage rates include unemployment levels, the value of the U.S. dollar, inflation, the bond market — even the price of oil. The unemployment rate has more of an effect on short-term home loan rates, as opposed to long-term loans. At times of high unemployment, the Federal Reserve will often adjust short-term rates in order to give a boost to the economy.

For example, at the time this article was published (November 2011), the unemployment rate in the United States was around 10%. This is a fairly high level of unemployment, so the Fed was taking proactive steps to lower interest rates. These adjustments in short-term interest rates affect the mortgage rate you might receive for an adjustable-rate mortgage (ARM).

The rates for long-term mortgages, such as the 30-year fixed, are more heavily influenced by conditions within the secondary mortgage market. This is where mortgage-backed securities are bought and sold.

When a lender gives you a home loan, they generally don’t keep it on their books. In most cases, they would rather sell the loan into the secondary mortgage market. This gives them additional funds with which they can make more loans. (Lenders make a profit by charging interest and fees on the money they lend. So they make more money by lending more often.) These loans are often bundled into what is called mortgage-backed securities, or MBS. The interest rate lenders assign on home loans are partly determined by the demand for these securities.

How the Lender Assigns Your Rate

So this is how we come up with average interest rates on home loans. But if you remember from the introduction to this article, there is often a big difference between average rates and the actual rate you receive from the lender. That’s because the lender may adjust your interest rate upward or downward, based on your qualifications as a borrower.

When it comes time for the lender to assign an interest rate on your home loan, it may be higher or lower than the average rates at that given time. If they consider you a well-qualified borrower, they might charge you less than the average borrower. If they consider you a higher risk for some reason, you will probably pay more in interest and fees.

You can think of the average rates as a baseline. This baseline is determined by the economic and market factors we discussed earlier. When an individual borrower applies for a home loan, the lender will adjust the rate from the baseline depending on the borrower’s qualifications. So what are these qualifications?

Credit Scores, Down Payments and Risk

Your credit score has a lot to do with the rate the lender assigns to your home loan. With all other things being equal, a higher credit score will help you secure a lower rate. A lower score will probably result in a higher rates. This is why it’s so important to maintain a good credit score. It can make the difference between mortgage rejection and approval. And if you do get approved, your credit score will partly determine whether you get an interest rate that is above or below the average or “baseline.”

Credit scores are a numerical indicator of risk. A high score indicates a borrower who has responsibly repaid his or her debts in the past. A low score may be an indication that the person has neglected their debts in the past. Lenders assign interest rates on individual home loans largely based on risk. So if that three-digit number flags you as a high-risk borrower, you can probably expect to pay more in interest.

The size of your down payment will also influence the rate you receive. Here again, it has to do with risk. Consider the difference tween a 5% down payment and a 20% down payment. In the first scenario, the lender is covering 95% of the purchase price. They have a substantial investment in the home, so they are exposed to more risk. You can expect to pay a higher interest rate in that scenario.

When a borrower makes a down payment of 20%, the lender is exposed to less risk. So they may assign a lower interest rate on the home loan. That’s what the term “risk-based pricing” means.

So let’s go back to the scenario I introduced at the beginning of this article. You see a certain interest rate advertised on the mortgage lender’s website. Take a closer look and you will probably see an asterisk (*) beside that number. This tells you that there are underlying terms and conditions related to this rate. And if you scroll down the page a bit, you will probably find the fine print that ties back to the asterisk. It will say something like this: “These rates are reserved for well-qualified borrowers.”

Essentially, this means that not every borrower is going to qualify for that advertised rate. The lender may assign a higher interest rate on your home loan, based on your qualifications. Or, if you meet their definition of a well-qualified borrower, you may be charged less interest than what they are advertising on their website.

Conclusion and Summary

On any given day, there is a certain baseline of interest rates available for home loans. They are determined by the secondary mortgage market and various economic factors. This is what the media are referring to when they mention “average mortgage rates.” But this is just the baseline, and the lender may adjust upward or downward based on the individual borrower’s qualifications.

So you have two tiers. The first tier is the baseline, and the second tier is the actual rate you receive from the lender. Depending on your financial situation, there might be a big difference between these two tiers. Or they might be essentially the same. It all comes down to how the lender views you in terms of risk. If you have higher risk factors than the average borrower (such as a smaller down payment and/or lower credit score), you can expect to pay more in interest.

This article answers the question: How do lender’s assigned rates on home loans? If you would like to learn more about this topic, I recommend using the search tool located at the top of this page. It gives you access to a research library that contains more than 500 articles.

Brandon Cornett

Brandon Cornett is a veteran real estate market analyst, reporter, and creator of the Home Buying Institute. He has been covering the U.S. real estate market for more than 15 years. About the author