What determines mortgage rates? Consumers need to understand what causes mortgage interest rates to rise and fall. The common belief is that banks, the Federal Reserve, mortgage lenders, Fannie Mae and/or Freddie Mac decide the interest rates of mortgage home loans. There are several factors that guide mortgage rates.
Let’s start with the process at a familiar level, acquiring the mortgage loan; when you acquire a mortgage, a mortgage company, bank or other mortgage lender provides you a loan at pre-determined mortgage rate. The loan may be held onto by the company itself.
However, in most cases, the mortgage lender sells the loan to a financial institution that bundles it up with other mortgages into a mortgage-backed security (MBS) and then sells that security to investors. That investor can be a financial institution, a mutual fund or a large institutional investor, who in turn earns a return on investment by collecting the principal and interest payments made by mortgage borrowers whose loan is packaged in the mortgage-backed security.
The packaged mortgage-backed securities are traded in the secondary market where Fannie Mae, Freddie Mac and other investors buy and sell trade for their portfolios. Due to the horse trading in mortgage loans, investors are in the driver’s seat when it comes to setting home mortgage rates.
As the economy starts heating up, mortgage investors demand higher yields from mortgage lenders. This is due to the fact that investors don’t want to purchase low-yield bonds now if Fed rate hikes (meant to cool the economy) will make higher-yield bonds available later. The only way mortgage lenders can then compete is to make their loans more attractive by increasing the yields they offer investors. Herein, this results in higher mortgage rates being charged to consumers.
The reverse happens when the economy is cooling. Investors start chasing bonds because they believe the Fed will cut rates in the future (to jump start the economy) and if they wait, they’ll end up possessing lower-yield bonds. Seeing as that the investor demand is intense, the lenders who control home loan supply can choose to offer lower yields. Thus, this results in lower mortgage interest rates for consumers.
Hence, inflation becomes critical component in determining mortgage rates. So if we examine mortgage rate fluctuations from the inflation prism, if inflation is on the rise, interest rates are on the rise as well.
Inflation affects mortgage rates because inflation dilutes the future value of the fixed interest payments the investors will get. Herein, investors will demand a hedge in the form of higher interest payments, meaning higher rates for home loan borrowers.
On the flip side, if investors believe inflation will head south in the future, they are more flexible in accepting lower rates.
Ultimately, investors are enticed into buying these mortgage securities by receiving interest rates that are competitive with alternative interest-paying investments such as Treasury bonds.
Yet, the mortgage rates don’t correspond to the Treasury rates. For example, a 30 year mortgage doesn’t track a 30-year Treasury bond, as are common assumptions. For it is, 30-year mortgages stay outstanding an average of 10 to 12 years, hence, rates on 30-year mortgages track the yields on 10-year Treasury notes.
Yet, the mortgage rates don’t correspond to the Treasury rates. For example, a 30 year mortgage doesn’t track a 30-year Treasury bond, as are common assumptions. For it is, 30-year mortgages stay outstanding an average of 10 to 12 years, hence, rates on 30-year mortgages track the yields on 10-year Treasury notes.
Since, the credit risk of the government is less than for the consumer; mortgages rates are higher than those on 10-year Treasuries. Usually, 30-year mortgage rates are about two percentage points more than treasuries but the spread can differ depending on the supply and demand for mortgage-backed securities and Treasuries as well as other contributing factors.
Basically, there are several spokes around the mortgage rate pivot that determine what interest rate you get for you home loan.