1. Inflation in the economy
Inflation measures how consumer prices rise — and how purchasing power falls.
It’s good to have at least some inflation; it means demand for goods and services is rising because people are buying stuff, which keeps the economy strong. Consumer spending drives about 70% of economic activity.
But when inflation is going up, mortgage rates climb, too, because lenders want to keep their rates above the level of inflation so it doesn't eat away at their profits.
Prices are currently rising at an annual rate of just 1%. On a 30-year mortgage at 3%, a lender really gets an annual return of just 2%, because the other 1% represents purchasing power lost to inflation.
Extra-low inflation in recent years has helped keep mortgage rates super low. If inflation were to jump to a 3% annual rate, lenders might raise mortgage rates to 5% or higher, to make up for their rising costs.
America's central bank, the Federal Reserve, tries to keep inflation under control. Which brings us to our next point:
2. The Federal Reserve's key interest rate
The Federal Reserve doesn’t set mortgage rates. But it does set a target for something called the federal funds rate, which is what banks charge each other for overnight deposits. When officials raise or lower the target, other interest rates can go up or down, too.
The Fed has a "dual mandate": to keep employment high and keep prices steady. When inflation is heating up, the central bankers try to cool it down by raising the federal funds rate. When the economy's in bad shape and people are losing their jobs, the Fed cuts the rate as a kind of economic CPR.
The central bank's interest rate moves don't have a direct impact on mortgage rates, but there is a strong influence.
When the Fed hikes rates, mortgage rates often follow suit. In the fall of 1981, for instance, the Fed used a high federal funds rate to fight inflation, and mortgage rates skyrocketed above 18%.
After Fed officials cut their key rate almost to 0% in March 2020, to protect the economy and jobs from the coronavirus pandemic, mortgage rates plummeted.
3. The bond market
After a borrower closes on a home loan, the lender may package that mortgage with a bunch of others and sell them on the secondary market. Fannie Mae and Freddie Mac are government-sponsored companies that buy, bundle, and resell those home loans as mortgage-backed securities.
They're investments that trade like bonds, which puts them in close competition to U.S. Treasury bonds. When the interest rates, or yields, on Treasuries rise, mortgage rates have to go up to keep mortgage-backed securities competitive with Treasuries.
The opposite is true, too: Mortgage interest rates fall with declining Treasury yields.
But the rates don't match up precisely. Mortgages are riskier than Treasuries, so mortgage rates are usually a bit higher.
4. The level of economic growth
When the U.S. economy is strong, people tend to earn more, spend more and borrow more. Homebuying heats up because more people qualify for mortgage loans.
But because banks only have so many dollars to loan out, lenders drive up mortgage rates to temper demand.
It also works the other way. When the economy is weak, employment drops and income declines — leaving fewer people to buy homes. In this environment, mortgage rates drop.
In 2020, the economy has been severely weakened by the pandemic, and mortgage rates have fallen to all-time lows.
5. The housing market
Trends in the housing market affect mortgage rates. When fewer homes are built or put on the market, fewer people buy homes. A shaky economy might drive more people toward renting instead of buying. These factors cause demand for mortgages to decline, which means mortgage rates drop, too.
But when more homes are constructed or sold, demand for mortgages increases — and mortgage rates go higher.
Average mortgage rates move with market forces you can’t control, but you do have some influence over the rate you get. Lenders will offer you a rate based on your credit score, debts, earnings and the home you choose.
Every lender has a different approach to risk, too, and different overhead costs. Rates can vary widely, so your best strategy for getting a low mortgage rate is to focus on factors under your control — and shop around by checking rates from multiple lenders.
Comparison shopping works well when buying or renewing your homeowners insurance, too, so you'll get the right coverage without paying too much.