How mortgage rates are determined
Key takeaways
04 · ideas- The Fed funds rate influences but does not directly set 30-year mortgage rates
- 30-year mortgage rates closely track the 10-year Treasury yield
- Loan-level price adjustments vary by credit score, LTV, and property type
- Mortgage-backed securities markets are the direct pricing mechanism
Basic level
The essentials · 1 min
Mortgage rates are determined by multiple interacting forces.
Federal Reserve: The Fed sets the federal funds rate. This directly influences short-term rates and adjustable-rate mortgages, but has an indirect relationship with 30-year fixed mortgage rates.
10-year Treasury yield: The most important benchmark for 30-year fixed rates. Mortgage rates typically track 10-year Treasuries with a spread that has historically ranged from 1.5% to 3%.
Mortgage-backed securities (MBS): Most mortgages are sold to investors as securities. The rate the lender offers reflects the rate at which they can sell the loan into the secondary market, plus a profit margin.
Intermediate level
How it applies · 2 min
The rate-setting process
When a lender quotes a rate:- MBS prices are checked for the current market rate
- Loan-Level Price Adjustments (LLPAs) are applied based on credit score, LTV ratio, loan type, property type, and loan size
- Lender profit margin is added
- Points can be paid to adjust the rate up or down
Rate lock: Committing to a rate for 30-60 days — longer locks typically mean slightly higher rates.
10-year Treasury spread history
| Period | Approximate spread |
|---|---|
| Pre-crisis average (2000-2007) | ~1.6% |
| Post-crisis (2009) | ~2.5-3.0% |
| 2022-2023 | ~2.7-3.0% |
The wider recent spread reflects increased mortgage market risk premium and capacity constraints.
Advanced level
The math, step by step · 1 min
Convexity risk in MBS
Mortgage-backed securities have negative convexity due to prepayment risk. When rates fall, borrowers refinance, returning principal to MBS investors earlier than expected. When rates rise, prepayments slow. This uncertain duration means MBS investors demand a yield premium — part of the spread over Treasuries reflects this convexity risk. During high-volatility rate environments, convexity hedging activity can amplify rate movements.