The mortgage interest rate is the price you pay to borrow large sums of money to buy your house. Since a typical mortgage loan is hundreds of thousands of dollars, the interest on that loan will be a substantial expense that you will incur for may years. Also the interest rate is a key factor in determining your monthly mortgage payment which will frequently limit how much you can spend on a house. Simply put, the interest rate is an important factor when making decisions about real estate and you have a strong vested interest in getting the lowest rate possible.

Assume for example, that you are shopping for a house. You’ve used some of the online mortgage calculators to determine that with an interest rate of, say, 5.5% you can afford to buy a $250,000 house resulting in monthly mortgage payments of roughly $1,420. So you take your time to evaluate the market and search for your dream house. Only while you are shopping around, interest rates increase to 6.75%. Now your mortgage payments will run $1,620, almost $200 a month more. Or, if you couldn’t afford the additional fee, you would have to reduce your house budget to down to $218,000.

The good news is that mortgage rates move gradually (see chart), and rarely move more than 0.1% in a given month. So the scenario above is unlikely provided that you aren’t shopping for a house for a year or more. However mortgage rates are volatile, and its not uncommon for rates to move .5%-1% from one year to the next. This volatility results in a strong inclination among homebuyers and sellers to seek to understand the prevailing winds of mortgage interest rates in order to get the lowest rate possible.

The Interest Rate Crystal Ball

Although mortgages are issued through a complex system, fundamentally, mortgages are loans made by investors who are compensated by receiving the interest on those mortgages. The investor’s willingness to provide funds for mortgages will be influenced by a complex set of factors that include: future inflation, 10-year treasury rate, the federal funds rate, the demand for mortgages, and the economic health of the US economy.

Mortgages and the Fed

Many people believe that the Federal Reserve (or Fed) sets mortgage rates, and certainly many news articles seem to infer that belief. The Fed does set short-term interest rates and lower rates are seen as a driver of economic growth. Also short-term interest rates determine longer-term interest rates, such as the yield on a 10-year Treasury bond (since most mortgages are paid off within 10 years, we compare even a 30-year mortgage with a 10-year bond). Since Treasury bonds are backed by the U.S. government, they are considered to be a risk-free investment. Since mortgages are not risk-free, the interest charged on a mortgage would need to be higher than that on Treasuries in order to encourage investment. So while the Fed does not control mortgage rates, they help to manage inflation and determine the interest rate on comparable investments, both of which are influential factors in determining mortgage rates.

Thus there are a number of economic indicators that combine to influence the direction mortgage rates are moving. In general the indicators influence beliefs about the economy. If the belief is that the economy is experiencing inflation, then the Fed may need to raise interest rates to slow the economy down. This would lead to higher mortgage rates. On the other hand, if the belief is that the economy is in recession, then the Fed may need to lower rates to jump-start economic activity. These indicators include:

• 10-year treasuries - Increasing yield on 10-year treasuries would lead to higher interest rates.
• Consumer Price Index (CPI) - An increasing trend in CPI is considered inflationary and may cause interest rates to rise.
• Federal Funds Rate - Lowering the federal funds rate (or short-term interest rate) is considered to be an indicator of expansionary economy which tends to lead to higher mortgage rates.
• Gross Domestic Product (GDP) - An increasing trend is considered inflationary which can raise concerns that the Fed may raise interest rates to slow growth, which would lead to higher mortgage rates.
• Unemployment Rate - A declining unemployment rate is considered to be inflationary which can lead to higher mortgage rates.
• Housing Starts - Increasing housing starts is considered to be inflationary which can lead to higher mortgage rates.

However you’ll notice one important thing – all of these data sources tell you what has already happened. They don’t tell you what will occur next month/year. Thus while they provide visibility into the conditions which have influenced the current mortgage rates, they do not tell you what future mortgage rates will be. And trying to predict future interest rates is practically an impossible task.

Getting the Lowest Rate

You cannot determine if mortgage rates will go up or down, but you can ensure that you’ll get the lowest rate possible. Let’s repeat that together – you cannot determine if mortgage rates will go up or down, but you can ensure that you’ll get the lowest rate possible. The tactics listed below can reduce your interest rate by as much as 1%, which can save you thousands of dollars.

Improve Your Credit Score

The first step is to actually find out what your credit score is. While you can get a credit report for free, you’ll have to pay for a report that includes your credit score. The higher your credit score, the lower the interest rate you can qualify for. A credit score of 720 or higher will generally qualify for the best interest rates available at any given time. If you don’t have a high credit score there are many resources that can help you to improve your score. However most credit-improving tactics take time. Ideally you would begin the process well over a year before applying for a mortgage. However if you haven’t taken this long view there are a few steps that can improve your score within months:

• Correct any significant errors by contacting the reporting agency (the address will be included on the credit report).
• Pay any recent past-due accounts. More recent late-payments hurt your score more than older ones do.
• If possible, pay down credit card balances. While financially, paying off the highest-interest rate card first is the smart move, from a credit score perspective, you want to pay down those that are closest to their limits. Getting balances below 30% of the limit on each card is a great goal.
• If you have any old credit cards you aren’t currently using, start to make small purchases and then pay the balance each month. This will give the account greater weight on your credit score.
• Don’t cancel any unused accounts or apply for new credit. These activities won’t help your score and they might hurt it.

Buying a house with less than 20% down will mean that you’ll either pay mortgage insurance or a higher interest rate.

Live in Your House

Loans for a permanent residence have a lower interest rate than those for investment homes, vacation homes, etc. Also if there is a co-borrower who does not intend to live in the house, this can raise the interest rate.

Get a Conforming Loan

A conforming loan is one which meets the criteria for Fannie Mae and Freddie Mac to buy it. Fannie Mae and Freddie Mac are two agencies that buy mortgages from cooperating lenders. Primarily this means that your loan amount does not exceed $417,000 for a single-family home. This doesn’t mean that you can’t purchase a house valued at more than $417,000, it just means that the amount of the loan must be lower than $417,000 to qualify as a conforming loan.

Get a Shorter Term Mortgage

If it’s financially reasonable, a 15-year mortgage will be less expensive than a longer (20, 25, 30, 40 year) term mortgage. In addition to the lower interest rate, a 15-year mortgage will result in significant interest expense savings since the balance is paid off much more rapidly. However many find that the higher monthly payments make this option financially unrealistic. For example, a 30-year loan on a $300,000 property at 6% would cost about $1800 a month. However the same loan with a 15-year term would cost over $2500 a month.

Although saving for a down payment and improving your credit score is not as exciting as making broad market interest rate predictions, it's significantly more likely to save you money on your mortgage. And although the economic indicators listed above are unlikely to help you predict future mortgage rates, they can help you gain some broad perspectives on the health and direction of the economy.

Additional Resources:

Mortgage Calculators

Current Rates

Credit Score

Lowering Your Score