How Mortgage Rates Work

Where Mortgage Rates Actually Come From

Most people assume the bank just picks a rate out of thin air, or that "the Fed sets rates." Neither is true. Here's the actual chain of events: when you take out a mortgage, your lender almost never holds the loan themselves. They sell it within days to a government-sponsored entity like Fannie Mae or Freddie Mac, which bundles thousands of mortgages together into a security and sells that to investors — pension funds, insurance companies, foreign governments, hedge funds. Those investors decide what yield they need to make the investment worth it, and that yield, working backward through the system, becomes your mortgage rate.

This is why mortgage rates track the 10-year Treasury bond yield so closely. Treasuries are the world's safest investment, and mortgage-backed securities have to offer a higher yield to compensate investors for the additional risk. When Treasury yields rise, mortgage rates rise. When inflation expectations climb, Treasury yields climb. When the economy looks shaky and investors flee to safety, Treasury yields fall and mortgage rates often follow.

The Federal Reserve influences this whole machine indirectly by setting the federal funds rate (what banks charge each other for overnight loans) and by buying or selling bonds. When the Fed buys mortgage-backed securities — as it did massively during the COVID-19 pandemic — it pushes rates down. When the Fed stops buying or starts selling, rates drift up. So the Fed matters, but it doesn't set your rate. The bond market does.

Fixed-Rate vs Adjustable-Rate (ARM): Which Should You Pick?

A fixed-rate mortgage locks your interest rate for the entire life of the loan. Your monthly principal-and-interest payment never changes, even if rates triple. The 30-year fixed is by far the most popular U.S. mortgage for a reason: it's predictable, simple, and lets you sleep at night.

An adjustable-rate mortgage (ARM) starts with a fixed rate for an initial period (typically 5, 7, or 10 years) and then adjusts annually based on a benchmark index. ARMs almost always start at a lower rate than fixed mortgages — often 0.5%–1% lower — which is the carrot the lender uses to compensate you for taking on the risk of future rate changes.

When does an ARM make sense? If you're confident you'll sell or refinance before the fixed period ends. Military families with predictable PCS moves, professionals on fellowship or short-term assignments, or buyers in a clearly temporary home all have legitimate reasons to consider one. When does it not make sense? If you might still be in the home when the rate adjusts. Plenty of buyers from the 2005–2007 era will tell you horror stories about ARMs that "couldn't possibly" reset higher — and then did.

APR vs Interest Rate: The Number That Actually Matters When Comparing Lenders

When you shop lenders, you'll see two rates quoted on every Loan Estimate: the interest rate and the APR (Annual Percentage Rate). The interest rate is what gets used to calculate your monthly payment. The APR is the interest rate plus most of the upfront costs of the loan (origination fees, discount points, mortgage insurance) expressed as a yearly percentage.

Why does it matter? Because two lenders can quote the exact same interest rate but charge wildly different fees. Lender A might offer 6.50% with $2,000 in fees. Lender B might offer 6.50% with $7,000 in fees. The interest rate doesn't reveal the difference — but the APR does. When comparing lenders apples-to-apples, look at the APR.

One caveat: APR assumes you keep the loan for its full 30-year term. If you plan to sell or refinance in 5 years, the upfront fees hit you harder than the APR suggests. For short timelines, focus on closing costs and the actual interest rate, not the APR.

Mortgage Rates FAQ