The Key Factors That Affect Mortgage Rates More Than Anything Else

When mortgage rates go up, so do monthly payments on new loans.

The rate you land depends on your financial situation, the home you’re buying and the area where you live. But other, bigger factors are at play, like the state of the overall economy and trends in the housing market. Those can help drive average mortgage rates higher or lower.

Take a look at the five factors that have the most impact on mortgage rates.

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.