In general, it is accurate to think of interest rates as the cost of money. Lenders charge interest when they advance money to borrowers in order to earn a return on their capital, just as vendors charge a price for their products in order to earn a return. Mortgage rates are the cost of borrowing funds specifically to pay for a house or building.
There are many factors that go into establishing a mortgage rate, including the demand and supply of mortgage funds, the discount rate that the U.S. Federal Reserve sets for banks, the market for mortgage-backed securities (MBS), and the borrower’s risk profile, among other factors.
While the economic and market factors noted above (the Fed and the MBS market) set the baseline for aggregate mortgage interest rates, specific mortgage rates to individuals are partially determined by the supply of and demand for mortgage money. This is because mortgage lenders do not have infinite sums to lend. They must manage their loan portfolios to maximize returns and minimize risk.
The primary mechanism they use to accomplish these goals is the interest rate. When there is higher demand for mortgages, mortgage lenders can use the interest rate to determine how to allocate funds. Moreover, generally if the buyer can make a larger down payment, it will result in a lower mortgage rate because it reduces default risk and lowers the amount of funds that the buyer must borrow.
To illustrate, if the house costs $20,000 and the buyer can make a $2,000 deposit, there is $18,000 that must be borrowed. However, if the buyer can place a $5,000 deposit on the house, only $15,000 must be financed. Lenders will generally offer lower mortgage rates because the amount of the mortgage is lower with a higher down payment. Also, when the buyer has money invested in the property already, it reduces the chance that the buyer will risk his or her investment by defaulting on the loan.