Risk-free Rate

• The risk-free interest rate is the most basic determinant of other rates in the market. The risk-free rate is what investors expect to earn as a result of merely "tying up" their money for a predetermined period of time, with no possibility of default by the borrower. Since the U.S. government can always repay its debt by printing more money, the rate on Treasury bonds is considered the risk-free rate in the market.
  
  

Risk Spread

• Since practically any non-governmental borrower will have some possibility of defaulting on the debt, investors expect to earn a higher rate of interest when lending to conventional borrowers, such as individuals or corporations. This difference between the risk-free rate and the rate of interest on a risky loan is referred to as the "risk spread" or sometimes as "spread." A large corporation may be charged "Treasury rate + 0.75 percent" for instance. So, when the Treasury bonds yield 2 percent, the interest rate on this loan would be 2.75 percent per year. For residential mortgages, potential borrowers usually receive a simpler quote such as 4.75 percent, as opposed to a spread, as many laypeople do not follow Treasury bonds and may not know the current interest rate on them.
  
  

Positive Correlation

• Due to the risk spread, there is a strong positive correlation between the Treasury bond rates and mortgage rates. As treasury bond rates go up or down, the mortgage rates move usually in the same direction. In addition to strongly influencing mortgage rates, changes in Treasury bond yields also have a marked impact on rates charged for credit card balances, car loans and other types of borrowing.
  
  

Government-Backed Mortgages

• To increase home ownership, the U.S. government backs residential mortgages in a variety of ways. Agencies such as Fannie Mae and Freddie Mac will usually step in to cover most losses of lenders if a homeowner fails to make payments. Therefore, lending money to a home buyer is a bit like lending to the government. Due to this, and a few other reasons, rates on residential mortgages are far below the rates charged for consumer loans.
  
  

Residential vs, Commercial

• The government's guarantee of most residential mortgages makes the rates on these loans more similar, from a risk perspective, to Treasury bonds. Commercial mortgages, on the other hand, do not carry a government guarantee. Therefore, residential mortgage rates are influenced more directly by movements in the Treasury bond market, whereas commercial mortgage rates are more complicated and are impacted by many other factors in addition to Treasury bond rates.