Inflation

• Inflation describes increasing prices for the same goods over time. Though there have been limited periods of deflation, or prices decreasing, the consistent trend over the long term has been inflation. This affects lenders because if they didn't charge interest on a loan, they would be losing purchasing power over the life of the loan. For example, if they lent you $20,000 in 1980 and you paid back the full $20,000 in 2000, even though the dollar amount is the same, the purchasing power has decreased. Therefore, the higher the expected rate of inflation over the life of the loan, the higher the interest rate.
  
  

Risk of Default

• Lenders charge interest to cover their investments against the risk that some of them will default on their payments. Lenders judge the rate of interest needed to make up for defaults by your credit history and the current economic conditions. Lenders look at your credit score to determine how likely you are to pay your mortgage as agreed. They also look at the current economy, because in recessions and depressions the chances of someone losing a job and having to default on the loan increase drastically.
  
  

Treasury Bills

• Treasury bills are issued by the government and are arguably the most secure loans available for investors looking for fixed-income securities because the chances of the United States government defaulting on its debt payments is virtually zero -- even in bad economic conditions. Mortgages are also effectively fixed-income securities but with more risk, so the interest rates on mortgages will be higher than treasury bills.
  
  

Competing Investments

• Investors are always looking to maximize their returns, so the higher the returns from other investments like stocks or mutual funds, the fewer dollars will be available for issuing mortgages. When fewer dollars are available, the supply is low. Therefore, the price rises. In the case of mortgages, the interest rate rises. If other investments are not performing well and mortgages represent a better investment, more money will be available to be lent and interest rates will fall.
  
  

Federal Reserve Rates

• Contrary to popular belief, the Federal Reserve does not set interest rates but only suggests interest rates for overnight lending between banks. These overnight loans are drastically different than mortgages, which often last a decade or longer. Usually the rates move in unison, meaning when Federal Reserve rates rise so do mortgage rates. However, there are times when they have an inverse relationship, such as when investors believe the Federal Reserve is lowering rates because of a struggling economy.