Who Sets Mortgage Rates? Everything You Ever Wanted to Know

Sure, you can google, “who sets mortgage rates?” and, “why do mortgage interest rates change?” But, you’ll probably be a bit baffled by the results. Is it the Federal Reserve or the 10-year Treasury yield that determines rates? And wait… what exactly are the Federal Reserve and 10-year Treasury yield? Not to worry. We’ll explain it all so you can understand why mortgage interest rates work the way they do.

So, Who Sets Mortgage Rates? Read On to Learn:

  • What the Federal Reserve is and how it affects interest rates
  • A description of the 10-year Treasury yield and its impact on rates
  • The reason why mortgage interest rates are higher than the 10-year Treasury yield
  • How your personal finances can impact your interest rate

What’s the Federal Reserve and How Does it Affect Rates?

You might have heard that the “Fed” sets mortgage interest rates but that’s not exactly true. The Federal Reserve’s policies impact rates, but do not have a direct effect on them. Here’s why:

  • The Federal Reserve is the central banking system of the U.S. It works to maintain financial stability for the country and to minimize inflation rates.
  • If the Federal Reserve wants to improve the economy, it can create policies to do so. One way they do this is by making it less expensive for financial institutions to borrow money. That means, borrowing money probably becomes less expensive for everyone.
  • Of course, the Fed can do the opposite by making funds more expensive if they want to slow the economy down. The Federal Reserve doesn’t directly create mortgage rate changes. But, the interest rates they set for what banks charge each other has a strong influence. You’ll find out why this is important in just a minute.

What Role Does the 10-Year Treasury Yield Play?

Let’s start with why the 10-year Treasury yield exists. The Federal Reserve sells 10-year Treasury bonds (and bonds with other durations too) for $1,000 each, which can be purchased by investors. These investors are usually banks or other financial institutions. Basically, investors loan money to the government by purchasing a bond. In return, bondholders are guaranteed an interest payment every six months. After a decade of interest payments from the government, the investor is repaid the initial $1,000 invested; the principal.

Treasury bonds are viewed as one of the “safest” investments since the government has never failed to repay the promised amount. Even better, financial institutions and investors can sell Treasury bonds to others in a secondary market (and to fund the money they lend to others). This is where the “yield” of the 10-year Treasury bond comes in. But before we get into the details of Treasury bonds and their yields, here’s what you really need to know – in a nutshell:

30 year Mortgage interest rates tend to track the 10-year Treasury yield. When the yield goes up, so do mortgage rates. The opposite is true when the yield goes down.

Good with the basics? Go ahead and skip the rest of this section. We recommend picking back up in the “Personal Finances” section below. Are you a number-nerd or just a very curious human? Read on here…

The Secondary Market

The secondary market refers to the selling of pre-owned Treasury bonds by investors and financial institutions. The amount existing bonds are sold for determines the 10-year Treasury yield.

Low Yield Market
  • When demand is high and Treasury prices rise, yields fall. That’s because someone buying a bond on the secondary market will have to pay more than the $1,000 face value, thanks to all the purchase competition.
  • Of course, when you buy something at a premium price, you make less money by owning the bond (because you paid more for it). In other words, the financial yield on that bond is lower.
  • Low yields on Treasuries mean lower rates on mortgages.
  • Sure, investors make less money on lower-yield bonds. But, selling these bonds is easier, since lots of people want to buy them (ie: high demand).
  • That means lending money overall is less risky. And interest rates always come down to risk. Less risk equals a lower rate.
High Yield Market
  • When demand for Treasury bonds is low, investors can buy them at a discount.
  • This situation is the opposite of the low yield market described above; when you buy a bond for less than face value, you’ll make more money by owning it (because you spent less when you bought it). In other words, the financial yield on that bond is higher.
  • In the high yield market, selling bonds (and other loans) becomes more difficult. That’s all because of the low demand in this scenario.
  • And that means the higher the Treasury yield, the higher the mortgage interest rate.


Low Yield – You buy a handful of 10-year Treasury bonds from an existing bond owner for $1,100 each, instead of $1,000. You pay more for the bonds because many other investors are interested in them too. It’s the supply and demand relationship you probably learned about in Econ 101. High demand for Treasury bonds usually happens when investors think the economy might not be doing so well. This means that an investment with almost no risk – like a Treasury bond – becomes more attractive. Because of the higher price you paid for the bonds, you’ll make less money back when the government reimburses you for the face value of the bonds.

High Yield – You buy a handful of 10-year Treasury bonds from an existing bond owner for $900 each, instead of $1,000. You get this great discount because there aren’t many other investors interested in buying these bonds. (Those other would-be bond purchasers are probably buying more risky types of investments because the economy is doing pretty well). Because of the low price you paid for the bonds, you’ll make more of a profit when the government pays you back for the face value of the bonds.

All this buying and selling of 10-year Treasury bonds is referred to as the secondary market. The market selling rate gives us the 10-year Treasury yield.

Then Why are Mortgage Interest Rates Higher Than the 10-Year Treasury Yield?

Now that you have an idea of how “risk-free” treasury bonds influence mortgage rates, let’s talk about the mortgage-backed securities market (MBS). Mortgage-backed securities are issued by companies like Cardinal Financial. They contain mortgages Cardinal Financial lends, plus loans from other industry participants.

These bundles of home loans have additional risk when compared to Treasuries. Namely, “prepayment risk”. Here’s why:
  • Remember, with 10-year Treasury bonds, one receives a fixed rate of interest for 10 years and then receives the initial principal investment back at the end of the 10 year period.
  • Since mortgage-backed securities contain loans made to individuals for their homes, those individuals have the option to pay the loans back at anytime. The loan gets repaid whenever a mortgage borrower refinances, sells their current home, or just becomes able to pay their mortgage in full.
  • If a loan gets repaid before the end of the mortgage term, the holder of the mortgage-backed security stops earning interest on the loan. That means less money for the loan holder.
  • Early mortgage payments tend to increase and decrease at times an investor would not prefer. For example, when rates are dropping and the price of their mortgage-backed securities investment should be going up, it’s also the time when borrowers are more likely to refinance and return the principal.
  • Conversely, when rates are going up and the price of the mortgage-backed securities investment is going down, borrowers are less likely to refinance and return the principal, thereby extending the period with lower mortgage-backed securities prices.
  • Remember the “higher risk equals higher rates” thing? It comes into play here too. This “prepayment” risk results in higher rates associated with mortgage-backed securities as compared to Treasuries. That’s why mortgage interest rates are higher than the 10-year Treasury yield.

How Do Your Personal Finances Factor In?

Now that you know how general mortgage interest rates are set, it’s time to talk personal finances. Your income and financial history play big roles in the amount of risk a mortgage lender takes when they give you a loan. Just like with Treasury bonds, higher risk means a higher interest rate and lower risk means a lower interest rate.

So, how do lenders determine risk (and therefore, your rate)? These are a few basic factors:

  1. Your credit score – Basically, the higher your credit score, the lower your interest rate is likely to be. Since your credit score tracks your financial history, a higher score tells the lender that your loan is less risky than a lower score.
  2. Your monthly income as compared to your monthly debt – The more money you have leftover after paying your monthly bills, the less likely you are to skip a mortgage payment. This means that people with a higher percentage of leftover income (after paying debts) present a lower risk to lenders. And, you guessed it, that means a lower interest rate. The calculation of income compared to debt is known as the debt-to-income ratio.
  3. Your down payment percentage – This one’s simple. The more of your house that you pay for up-front, the lower the risk to the mortgage lender – and the lower the rate. That’s because the financial burden on a borrower is higher than if they make a smaller down payment (say, 3%). On the other hand, someone who makes a larger down payment (say, 20%) faces less of a repayment load. So, higher down payments signal a higher likelihood of monthly mortgage payments (and less risk to the lender).
  4. The length of your loan – The longer the loan, the higher the interest rate. That’s because, to lenders, more time waiting for repayment means more time for someone to default on their loan. Plus, money is worth less when paid back later because of inflation. So, longer loans are higher-risk.

The takeaways? Keep your eye on the 10-year Treasury yield if you want to track mortgage interest rates and focus on your personal finances for your lowest rate.

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