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Mortgage rates determine what you pay for a home loan. If you’ve never purchased a home before, here’s a simple rule of thumb to follow: The lower your mortgage interest rate, the better!
Paying interest on a home loan is just like paying interest on a credit card or another loan. It adds to your total cost of borrowing.
So what is a good mortgage rate? And how can you get the lowest mortgage rate when buying a home for the first time?
Here’s a closer look at mortgage rates explained.
What is a mortgage interest rate?
A mortgage interest rate represents a premium you pay to borrow money. Lenders charge interest on home loans, which is repaid along with the principal.
Your mortgage interest rate determines what you pay for a home over the life of your loan. Specifically, the mortgage rate can influence the total amount of interest paid as well as the amount of your monthly payment.
It’s worth pointing out that a mortgage interest rate isn’t the same as the APR on a mortgage. Your mortgage APR or annual percentage rate reflects your annualized cost of borrowing and it includes the interest rate on the loan as well as other costs. Those other costs can include:
- Fees the lender charges
- Mortgage insurance
- Discount points
- Certain closing costs that are rolled into the loan
In that sense, a mortgage APR is similar to a credit card APR. Both mortgage rates and mortgage APRs are expressed as a percentage. It’s important to know the difference, however, so you can make apples-to-apples comparisons when you’re shopping for a home loan.
How do mortgage interest rates work?
Mortgage rates are applied to the principal on your loan. Interest is amortized over the life of the loan. Generally, you’ll pay more toward the interest than the principal in the early part of your loan. As you get closer to the end of the loan, more of your payments go to the principal.
Once you close on a home loan, your lender will give you an amortization schedule. This schedule shows you exactly how your payments are applied, including what goes to:
- Private mortgage insurance, if you’re paying it
- Escrow (for homeowner’s insurance and property taxes)
In terms of how mortgage rates are set, that’s determined largely by economic conditions. Mortgage rates tend to follow the movements of the bond market and the 10-year Treasury note yield.
What you actually pay for a mortgage depends on where mortgage rates are in general, but it also hinges on your personal financial situation. That includes your credit score, debt-to-income ratio, income, and assets.
Fixed rate vs. adjustable rate: What's the difference?
Mortgage rates can be fixed or adjustable. Whether you choose a fixed or adjustable rate can make a difference in how much you pay for a mortgage.
Fixed mortgage rates explained
A fixed mortgage rate is set at the beginning of the loan term and remains the same for the entire life of the loan.
For example, say you take out a 30-year mortgage with a fixed rate of 3.4%. Your rate would stay 3.4% for the full 30-year loan term.
The advantage of choosing a fixed rate mortgage is predictability. Since your rate is always the same, you know exactly what you’ll pay to borrow. And you don’t have to worry about your monthly payments fluctuating. That can make budgeting for a home easier.
Adjustable mortgage rates explained
An adjustable mortgage rate is tied to an underlying benchmark rate. This is also called an index rate. Adjustable rate mortgages or ARMs can use any of these rates as a benchmark:
- Weekly constant maturity yield on one-year Treasury bills
- Secured Overnight Financing Rate (SOFR), which replaced the LIBOR
- 11th District Cost of Funds Index (COFI)
The most important thing to know about an adjustable rate mortgage is that the rate doesn’t stay the same for the life of the loan. Instead, you typically pay one set rate for the first few years of the loan. Then the rate adjusts to reflect its benchmark rate.
So, for example, you might get a 5/1 ARM or a 7/1 ARM. With these loans, you’d have a low fixed rate the first five or seven years. Then the rate would adjust.
One pro about ARMs is also a con. As long as the benchmark rate remains low, your mortgage’s adjustable rate stays low, too. It’s possible you could pay less for an ARM compared to a fixed rate mortgage.
But if the benchmark or index rate increases, your mortgage rate goes up and so does your payment. So you don’t get the same predictability that you would with a fixed rate loan.
What is a good mortgage rate?
When you talk about a good mortgage rate, there are some rules of thumb to keep in mind.
First, it’s important to consider the average mortgage interest rate at any given time. If you look at data from Freddie Mac, a government-sponsored enterprise that helps fund mortgage loans, the average 30-year mortgage rate was 2.93% as of June 17, 2021. That’s considered near historic low rates.
If you go back a year, you’ll see that average mortgage rates were around 3.13%. But what if you go back 40 years, to June 1981? You might be surprised to learn that the average mortgage interest rate was 16.74%. That’s the same as what you might pay for a credit card APR now.
So, a good mortgage rate now is ultimately a reflection of what’s happening with the economy and how rates are trending. In terms of a good mortgage rate for you personally, that’s going to depend on what kind of rates you’re able to qualify for. Again, that all goes back to your credit history, income, and other financial details.
What causes interest rates to rise and fall?
The way mortgage rates move isn’t necessarily determined by any one thing. Instead, rates can be driven up or down by a number of factors, including:
- Stock market movements and volatility
- Inflation rates and whether they’re rising or falling
- Unemployment rates and new job creation
- What’s happening with foreign markets
When the economy is going strong, unemployment is low and consumers have money to spend on homes, it’s typical to see mortgage rates rise. On the other hand, if the economy is sluggish and new job creation dwindles then you may see mortgage rates fall.
The correlation between mortgages and homebuying activity is also important. When rates are low, it’s not uncommon to see more of a push toward homebuying or mortgage refinancing. When rates rise, there may be fewer buyers or homeowners looking for purchase or refinance loans as borrowing becomes more expensive.
Tips to get the best mortgage interest rates
If you’re planning to buy a home, then knowing how to get the lowest mortgage rate matters. Remember, the lower your rate, the more money you can save on interest over the life of your home loan.
Each lender sets rates differently, so it’s important to shop around for mortgage loan options. While you’re comparing loan terms and rates, also consider what lenders are looking for in terms of:
- Credit scores
- Payment history
- Total outstanding debt
- Debt-to-income ratio (this is how much of your income goes to debt repayment each month)
- Employment history
- Savings and other assets
- Down payments
As far as what is a good credit score for a mortgage, it can depend on the loan and the lender. Your down payment, the size of the mortgage, and the type of the property can also come into play.
With an FHA loan, for example, it’s possible to get approved for a mortgage with a FICO credit score as low as 580. But if you’re interested in a conventional mortgage or another government-backed mortgage like a USDA loan, you may need a higher minimum credit score to qualify. VA loans, designed for veterans and their families, have no minimum credit score requirement.
Putting your best foot forward, credit-wise, can help with getting the lowest mortgage rates. So that means doing things like:
- Paying bills on time
- Keeping your credit utilization low
- Keeping older credit accounts open
- Holding off on applying for new credit
You can also potentially boost your credit score by cleaning up credit reporting errors. You can get a free copy of your credit reports through AnnualCreditReport.com to review them for errors or inaccuracies. If you find a credit mistake, you can dispute it with the credit bureau that’s reporting it to have it removed or corrected.
This guide to mortgage rates covers some of the most important things to know when preparing to buy a home. If you’re ready to buy, working out how much you can afford matters for sticking to your homebuying budget. That includes checking the latest mortgage rate as well as your credit to get a sense of what rates you might qualify for. You can also prepare for buying a home by setting up a separate bank account for your down payment and closing costs. This way, you’ll have the money you need ready to go once it’s time to sit down at the closing table.