An Introduction to Mortgage Rates

Mortgage rates are one of the most important variables in our economy, as they’re a key component

in determining housing affordability and monthly payments on what’s typically the single biggest

expenditure for a majority of Americans. With most households’ wealth tied to housing, it’s

extremely important to understand how these rates are determined and where they could be heading.

What Determines Your Mortgage Rate?

Mortgage rates are essentially composed of two different financial indicators: the “risk-free rate” and the borrower “risk spread,” neither of which are as abstract as they sound. Your mortgage rate will equal the risk-free rate plus your borrower-specific risk spread. The formula looks like this:

Mortgage Rate = 10-Year Government Yield + Risk Spread

What is a “risk-free rate?”

The risk-free rate is represented by the U.S. Treasury 10-Year Bond yield. This is because the financial world considers lending to the U.S. government as close to “risk free” as is earthly possible. In order to make your loan, the bank from which you get your mortgage will typically borrow money at a rate very close to the U.S. Treasury 10-Year Bond yield. This is important, as fluctuations in government bond yields, which may happen as the Federal Reserve normalizes its interest-rate policy in the coming years, will trickle into mortgage rates. Banks lend to you at a higher rate, hoping to capture the risk spread, which is the second component of a mortgage rate.

What is the “risk spread”?

The risk spread is the part of the mortgage rate that’s very dependent on the borrower, a.k.a. you. It varies significantly with respect to the borrower’s credit score and history, the size of the down payment, the size of the loan, the metro in which the loan is being sought, and the length of the loan.

The risk spread will rise as the bank’s perception of a potential default rises. The worse the borrower’s credit history and score, the higher the risk spread the bank will assign as their perceived risk of a default rises. The lower the down payment, the higher the risk spread will be as well, as the borrower has less equity in the home and is showing a relative lack of financial resources. Additionally, the longer the loan, the higher the rate will be, because the longer time horizon increases uncertainty and default chances, for which the bank needs to be compensated.

So if rates are so dependent on the individual borrower, what’s this 30-year mortgage rate I see quoted on TV? 

This advertised rate is merely the average of all of the 30-year fixed-rate mortgages (the standard mortgage loan) given out during that time period. So that means roughly half the loans given out during that period have rates above the quoted level and half below.

What’s not usually shown is the variance between higher- or lower-risk loans, or how wide this range is. And as we mentioned earlier, this range can vary significantly depending on the characteristics of the individual borrower. However, it does tend to track bond yields very closely, as shown by the graph below.

Here are mortgage rates plotted against 10-Year Treasury yields:

Mortgage Rates vs. 10 Treasury Bond Yields

Sources: U.S. Treasury, Freddie Mac

While there are some minor differences in when rate moves start and how severe they are (and some of this was distorted by the Fed buying mortgage bonds as part of quantitative easing), they roughly track each other, with mortgage rates averaging roughly 180 bps or 1.8% higher. This means the average risk spread is usually around 1.8% to 10-Year Bond yields. This spread can vary based on the borrower, of course, but this provides a good baseline of what to expect when shopping for mortgage rates.

So to wrap up:
  • Mortgage rates are basically 10-Year Government Bond Yields plus the borrower-specific risk spread
  • What you see on TV is an average of all of the mortgages given out over the previous week
  • Mortgage rates will fluctuate with bond yields, which is important because as the Fed begins to normalize policy, it may affect yields.
Finally, the average risk spread has recently been around 1.8%, but this can vary when you go to the bank depending on your credit history, the size of your down payment, and how large a loan you’re seeking
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