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How do lenders calculate your mortgage rate?

Would you believe it if we told you that the biggest determinant of your mortgage rate has nothing to do with your own financial situation? That is a surprise to many who hear about it. But it is true. Here we explain what that factor is and then talk in detail about all the other major factors.

We have been hearing a very common question lately: “The Fed has dropped the mortgage rates. Will my mortgage rate go down as well?” It’s a very obvious question to ask. Mainly because from past experience, people have observed that the two do move together, at least somewhat.

What many may not  know is how the two are related and connected. Additionally, people also wonder why their mortgage rate is higher while someone else they know is getting a lower rate, even though both have approximately the same credit scores.

The truth is that there are so many factors that go into how your mortgage rate is calculated that it often becomes complicated for one to understand. Let’s take a closer look and understand how it all works.

Treasury bonds are where it all begins

For those of you who don’t know what a bond is, it’s simply a promise. A promise to return the money that an individual or entity borrows from someone. When that same promise is made by the United States Treasury (which is essentially the government’s ‘bank account’), it is called a ‘Treasury Bond’.

In other words, the Treasury Bond is essentially a promise made by the government to pay you interest in addition to paying back your principal, after you lend the government money for a certain period of time. 

How does the government decide how much interest to pay to its bondholders?

The government doesn’t really decide how much interest it’ll pay. It’s the buyers of the bond who decide so. Or investors, as we call them. Just like you don’t decide how much rate you’ll pay on your home loan. Your bank does.

And how do investors come up with that rate? Well, when lending to the US government, default risk isn’t really a big issue. Why? Because the US government has the power to just raise taxes (or print money) and pay back whatever it owes. 

The biggest risk investors face is the risk of inflation. If things become expensive over time, they want their money to keep up and grow. In other words, if the price of all goods increases n an average every year, they want their money to grow at the same rate. That way, in the future, they can afford the same things they can buy today with their money. 

And how do investors determine how much the rate of inflation will be?

Investors have certain expectations of inflation. And that expectation is typically linked with the rate of economic growth in a country 

For countries like the US, Japan and Germany, that are fairly well developed, those rates of economic growth are not that high. Residents of these countries already own a lot of what they need, to live comfortably. So they don’t end up buying a lot more every year.

On the other hand, for developing countries like China and India, where economies are expected to expand a lot more in the coming years, there is more expectation of growth. A large fraction of the population don’t already own what they need, to have good lifestyles. So there is significantly more scope for economic activity and growth. As a result, rates of inflation in these countries are higher.

Let’s go through one more thing quickly and then get to mortgage rates

The one principle that binds all investment activity is: “The higher the risk, the higher the rate of return that an investor demands” 

Why so? Because if an investor gets the same return for two investments with different levels of risk, why would they ever put their money in the more risky investment. Would you, as an investor, ever do that? No. That would be irrational.

The only way investors are willing to put their money into riskier investments is because they expect to make a higher return on those.

The one principle that binds all investment activity is: “The higher the risk, the higher the rate of return that an investor demands” Click To Tweet

This idea not only applies to mortgages, but this is the fundamental idea that drives all of finance, including pricing of stocks, bonds, commodities, or any investment in general.

How does the risk-reward principle come into play when calculating mortgage rates?

Unlike governments, individuals don’t have the power to tax people and/or print money. They have to earn money before they can pay back what they owe to someone else. 

And that ability to earn is different for different individuals, based on their skills, education, income, assets liabilities and many other factors. Not only that, that ability can also change over time. People who have a good job today may not continue to have that forever. 

As a result, the lender always runs some risk of the individual not being able to pay back the loan in full. If an individual defaults on his loan payment, the lender runs the risk of losing his money. 

We are ready to establish the link between government bond rate and your mortgage rate

Say an investor demands a specific rate to lend money to the government. If he instead lends you that same money for your home, will they still accept that same rate? No, of course not. There is a higher risk of you not paying back compared to the government.

By the risk-reward principle, the investor will demand more to lend you the money. Mainly to compensate him for the additional risk he takes by giving his money to you.  

And how much more would the mortgage rate be?

Well, that depends on a lot of factors. At the end of the day, the lender mostly cares about getting his money back and earning the interest he asked for. We also call that as a borrower’s “ability to repay”.

The three major factors that govern your ability to repay are:

  1. Debt-to-income ratio (DTI) This is the ratio of your total monthly debt payments to your total monthly income, in short also called as DTI. Debt includes home loan, auto loan, education loan and any other kind of loan you may have.
  2. Loan-to-Value ratio (LTV) This is the ratio of the amount you took as loan to buy the home vs the market value of the home, popularly known in the industry as “LTV”. Say suddenly the economy goes south, people lose jobs and home prices decrease in value significantly. Fewer people will be able to make their payments and some might default on their payment. In a situation like that, if the bank has to foreclose and sell the home, their chance of recovering their investment is higher when the loan amount is lower.
  3. FICO score This is basically a measure of how good an individual has been with his debt payments in the past.

The assumption is that those who have higher scores are those who have made their debt payments on time and as promised. Such individuals are more likely to continue to do so in the future.

On the other hand, people with reckless spending styles and ill-managed finances are more likely to have defaults and hence lower credit scores. If someone has a history of that, they are more likely to not keep their promise in the future as well.

Remember, a lower DTI, a lower LTV and a higher FICO score will get you the lowest rate. That is what you have to aim for. Click To Tweet

How do those factors translate into mortgage rate?

The lower the DTI, the lower the risk for the investor and lower the mortgage rate he’ll ask you to pay. 

Same applies for LTV. If your loan amount is small compared to the value of the home, the lender’s risk is lowered and you’ll get a better rate.

Higher FICO scores lead to the same outcome. You have demonstrated a good history of paying back your debt. The lender will see you as less risk and offer you a lower rate.    

Remember, a lower DTI, a lower LTV and a higher FICO score will get you the lowest rate. That is what you have to aim for.

Is there anything else that lenders see as risk?

There is one more risk that the lenders end up facing. The risk of you prepaying the loan. 

What? Why is that a risk? As a lender, wouldn’t I be happy if the money is paid back in full and before time? In full, yes. All lenders love that. But before time, not really.

Banks and other lenders are in the business of making loans. The original principal is what they owe to depositors. Their revenue solely comes from the interest you pay them. If you pay back early, they will not be earning interest from you any more.

One would ask, well they can make a new loan and start earning interest again. A very fair point

Unfortunately, people prepay and refinance their loan only when interest rates go down. For a bank to be paid the loan amount in full is bad because the new loan the bank will make will be at a lower rate than what you were paying him so far.

This type of risk is called “reinvestment risk”. Because most mortgages in the US don’t have a prepayment penalty associated with them, people can refinance whenever rates fall. So lenders face that risk. Unfortunately, no one refinances when rates go up to make it even for the lenders.

That risk is not with specific borrowers only. It’s a risk they face with all borrowers in general. If borrowers were prohibited from early payment, all of us would have had slightly lower mortgage rates. But most borrowers are fine to have the option to prepay for a small cost in the form of a slightly higher mortgage rate.


  • Lender offered mortgage rates vary significantly from one lender to another, so it's important to shop for your mortgage. Get a quote.
  • Mortgage rates often (but not always) correlate with treasury bonds.
  • Lenders then add to that rate to compensate them for the risk of the loan being prepaid.
  • They then add more to that rate based on one’s DTI, LTV and FICO score.

There are other factors that can further influence the rate. For example, if a loan is guaranteed by a government sponsored entity, the risk for the lender is reduced. He is fine offering a slightly lower rate.

In another case, if a property is one’s primary home vs. an investment property makes a difference. Default rates on primary homes tend to be less than those on investment properties.

All of these idiosyncrasies are taken into account when calculating the final rate that a lender offers.

At Stem Lending, we offer two propositions:

Firstly, having decades of years of experience in finance. Our goal is to help connect you to the mortgage lender who offers you a lower rate.

Secondly, we have a lot of partner lenders and most of them are well established in the mortgage business.

Even for the same borrower, property address, different lenders actually view the credit risk differently based on their current mortgage portfolio, strategic mandates and underwriting guidelines, thereby offering different rates. 

Because we work with so many lenders, we scan the mortgage markets across all our partner mortgage lenders and find out who’s offering the personalized mortgage options for you, without you having to call each one separately and filling out a separate application.

If you are looking to refinance your mortgage or purchase a home, please reach out and we’ll help you save on mortgage.

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