How mortgage rates are set: rate, APR, points and locks

Two layers: the market and you

The market layer. A 30-year fixed rate follows long-term yields. Researchers at the Federal Housing Finance Agency (FHFA) describe the 10-year Treasury yield as the benchmark risk-free rate for the 30-year fixed-rate mortgage. The gap between the two is generally a measure of how risky the market views 30-year mortgages, for example because borrowers may prepay (FHFA Working Paper 14-2, 2014). That paper also found that other economic and financial factors, in addition to Federal Reserve policy, affect long-term rates. So mortgage rates move with the bond market, not with a single government decision.

Your layer. On top of that, the lender prices your loan. The CFPB’s rate tool lists the main drivers:

• Credit score. A higher score generally means more affordable loans and more lenders to choose from. See credit score and mortgage rates.
• Down payment. A higher down payment typically lowers your rate and also reduces the loan amount. See how much down payment you need.
• Loan term. A shorter term generally gets a lower rate, with a higher monthly payment but less total interest.
• Loan type. Conventional, FHA, VA and USDA loans are priced differently. See FHA loans, VA loans, USDA loans and conventional loans.

The CFPB adds that your credit history with the lender, your debts, savings, assets and income also matter.

Interest rate versus APR

The CFPB defines the interest rate as “the cost you will pay each year to borrow the money, expressed as a percentage rate.” The annual percentage rate (APR) is “a broader measure of the cost of borrowing money than the interest rate”: it includes the interest rate plus points, broker fees and other loan charges, so it is usually higher than the rate.

Two cautions from the CFPB. For adjustable-rate loans, the APR does not reflect the loan’s maximum interest rate. And “Don’t look at the APR alone.” Comparing a fixed-rate with an adjustable-rate APR can mislead, because the two may not include the same costs.

The APR also matters to the law. A loan is “higher-priced” under Regulation Z if its APR exceeds the average prime offer rate for a comparable loan by 1.5 or more percentage points on a first-lien loan within Freddie Mac’s loan limit, or by 2.5 or more above that limit (12 CFR § 1026.35(a)). Higher-priced first-lien loans on a principal home require an escrow account.

Points and lender credits

Discount points are upfront payments that lower your rate. One point equals 1 percent of the loan amount: on a $350,000 loan, one point is $3,500. Lender credits work in reverse, giving you money toward closing costs in exchange for a higher rate. They can appear as “negative points.”

The CFPB’s example uses a $180,000, 30-year fixed loan at 5.00 percent with no points:

A simple break-even check: $675 ÷ $14 a month is about 48 months. Points pay off only if you keep the loan longer than that. The CFPB does not give a break-even formula and tells you to ask for offers with and without points and to compare total costs over a short, a long and your most likely timeframe. If you may move or refinance soon, credits may suit you better.

Rate locks

A rate lock means your rate will not change between the offer and closing, if you close within the specified time and your application does not change. Locks are typically 30, 45 or 60 days, sometimes longer. Your Loan Estimate shows whether your rate is locked and for how long, and some lenders lock when they issue the Loan Estimate and some do not.

Know the risks (CFPB): if rates fall after you lock, the lock may keep you from the lower rate; if closing slips past the lock period, extending it can be costly; and a locked rate can still change if your loan amount, down payment, loan type, credit score or verified income changes, or if the appraisal comes in different than expected. Policies differ by lender, so ask.

Compare offers the right way

The CFPB says the interest rate is not the only cost of a mortgage. Points, mortgage insurance and closing costs also affect your total cost, so compare Loan Estimates from several lenders side by side. For the other lines, see closing costs explained and private mortgage insurance.

Where states differ

The way rates are priced is federal and market-driven, so a lender in one state does not have a different rule book. What differs by state is the rest of the monthly bill and the closing costs, such as property tax and title insurance. See closing costs in Texas or in California, and first-time buyer programs in Texas for state-run loan programs.