What Is a Mortgage Rate?

Understanding mortgage rates

Mortgages come in different shapes and sizes, but they all do the same thing.

They loan the homebuyer money for a specific period of time to fund a home purchase. A prospective homebuyer can choose from a range of term lengths for a mortgage, up to 30 years. They also have the option of choosing from an adjustable-rate mortgage (ARM) or a fixed-rate mortgage.

After a period of time with a fixed rate, adjustable-rate mortgages move according to a benchmark interest rate, while fixed mortgage rates are the same for the life of the loan.

What you should know about mortgage rates

If you're new to the home-buying process, dealing with mortgage rates might seem overwhelming.

Here are a few of the basics that every home purchaser should know.

You can choose either from an adjustable-rate market, often called an ARM, or a fixed-rate mortgage. An adjustable-rate mortgage is typically fixed for the beginning of the term and will then float after a certain period. For instance, a 5/1 ARM would mean that you pay a fixed rate for the first five years, after which the rate will adjust every year, typically according to the secured overnight financing rate (SOFR).

Some common term lengths for ARMs include 5/1, 10/1, and 7/1. You might also see ARMs such as 5/6, or 10/6, meaning the rate readjusts every six months instead of every year.

Banks typically offer a lower rate during the fixed period of ARMs than they do for fixed-rate mortgages because ARMs are lower-risk loans since there is basically no interest-rate risk for the bank once the rate floats.

Fixed-rate mortgages, on the other hand, tend to offer a modestly higher mortgage rate for the homebuyer, but are lower risk since the rate remains the same for the life of the loan.

Fixed-rate mortgages typically range from 10 to 30 years. A 30-year fixed-rate mortgage is the most common type of mortgage in the U.S. While shorter mortgage terms offer lower rates, the 30-year fixed-rate mortgage offers lower monthly payments than shorter fixed-rate mortgages and doesn't come with the risk of an adjustable-rate mortgage.

How mortgage rates are determined

A number of factors influence mortgage rates, including the Federal Funds Rate (FFR), or benchmark interest rates, the 10-year treasury yield, supply and demand, and other market dynamics.

Typically, 30-year fixed mortgage rates are priced based on a spread above the 10-year treasury yield. The 10-year treasury yield is considered the benchmark risk-free rate, serving as the basis of a slew of other interest rates.

The spread between the 30-year fixed rate and the 10-year treasury yield is usually between 1 and 2 percentage points, but it can get higher during periods of stress. For instance, if investors believe inflation is on the rise, which usually leads to interest rates going up, the spread is likely to widen, reflecting a belief that rates will go up. Alternatively, the spread can fall in more secure, stable periods.

If you're wondering whether mortgage rates will rise or fall, they typically follow the direction of the 10-year treasury yield and the federal funds rate, though they don't move in lockstep.

How to choose the right mortgage rate for you

Choosing the right mortgage for you will depend on your individual needs and your expectations of the future.

Once you get pre-qualified for a mortgage, you'll know how much you can borrow. That's not necessarily how much you should borrow; it's just the bank's determination of how much you can pay back.

You'll also want to consider how long you plan to stay in your home. If it's 10 years or less, you may want to choose an adjustable-rate mortgage. An ARM might also make sense if you're shopping at a time when mortgage rates are elevated, and you expect them to come down.

Alternatively, if you have the funds to afford a higher monthly payment, possibly because you're downsizing, you might want to consider a shorter-term fixed-rate mortgage, which would give you a lower interest rate and a significantly lower total cost over time, though the monthly payments would be higher.

Choosing a mortgage is a personal decision. It's a good idea to review your options with your real estate agent and your mortgage broker to figure out what's right for you.