How mortgage loan rates are determined and what causes them to move is an absolute mystery to most folks – and those who think they know are usually wrong. As a former mortgage banker I can tell you that a lot of people in the mortgage industry can’t even give you an accurate answer to that question. So what’s the mystery and misinformation all about? Let’s take a simple look, in plain English, at what moves mortgage rates and (just as importantly) what does not.
Ask a bunch of your friends what mortgage rates are based on and they will tell you they are not sure but it has something to do with Ben Bernanke and the Federal Reserve. Some of your more financially savvy friends may tell you that rates are based on the 10 year treasury yield. Both answers are incorrect. The simple truth is that mortgage rates are based on the mortgage backed securities (MBS) market. I know – this is starting to sound scary. I promise to keep it simple – here’s a quick explanation of what a mortgage backed security is. Banks and mortgage lenders take large bundles of their mortgage loans and pool them together to be sold as investments. These debt obligations trade as bonds (mortgage backed securities). An investor can invest in a pool of mortgage loans and receive income based on how those loans perform (do they pay on time etc…). The mortgage backed securities market is a segment of the overall bond market. The MBS market reacts and moves based on economic news and indicators similar to how the overall bond market works.
To take this one step further, here’s the technical explanation for those of you who are knowledgeable in matters of finance. MBS rates, and consequently mortgage rates, are directly determined by variances (or spreads) between it (MBS Rates) and a financial derivative instrument called interest rate swaps. These swaps are used by investors to manage, hedge, or speculate on risk. The rate on a swap rate is a fixed interest rate that one would receive in exchange for the uncertainty of having to pay the short-term LIBOR (London Interbank Offered Rate) rate over time. Additionally, mortgage rates are influenced by relative spreads between interest rate swaps and treasury notes.
So why does everyone think that the Federal Reserve controls mortgage rates? Your guess is as good as mine. The most likely cause is that misinformed people in the media just keep talking about the fact that the fed lowered interest rates and mortgage rates will follow suit – and we keep listening. The fact of the matter is that the actions of the Federal Reserve do have an impact on mortgage rates but it is indirect and often extremely delayed. When the fed announces that they are lowering short term interest rates, this has an immediate impact on some types of consumer loans such as home equity loans and credit cards. It also has a negative affect on the interest rates on saving vehicles like money market accounts and certificates of deposit (because those rates go down as well). It does not however, have an immediate or direct impact on mortgage rates. The indirect impact on mortgage rates of the fed easing (lowering) short term rates is that it causes investors to flee investments like money markets and CDs and put more money into the stock and bond markets. When people buy more bonds (including mortgage backed securities) this causes bond prices to rise. When bond prices rise, the yields of those bonds go down. Lower yields on mortgage backed securities equal lower rates. This chain of events that started with the fed lowering rates and ended with mortgage rates going down could take months to unfold and dozens of other economic events could intervene and keep that chain of events from happening as predicted.
The other common misconception is that mortgage rates are tied to the long term Treasury notes. Not true. If you look at long term charts for mortgage rates and long term treasuries side by side you will see that they trend together over a long period of time. As mentioned above, the spread between interest rate swaps and treasury notes do influence mortgage rates – but it is inaccurate to say that there is a direct link between the two.
We’ve just covered the basics on how long term mortgage loan rates such as the 30 year fixed rate are determined. Short term mortgages like 5 year ARMs and 7 year ARMs can be based on a number of different indices.