Monday, March 19, 2012

How are Mortgage Rates Determined?


How Are Mortgage Rates Determined?
One of the most important aspects to successfully obtaining a mortgage is getting the best interest rate. For most homeowners, this means securing the lowest, fixed interest rate (no negative amortization!).
Many homeowners rely on their bank or mortgage broker to secure their interest rate, often without researching mortgage lender rates or inquiring about how they move. Whether you’re interested in rates or not, it’s wise to get a better understanding of how mortgage rates move, and why.
After all, a change in rate of a mere .125% to .25% could mean thousands of dollars in savings each year.
So how are mortgage rates determined?
Although there are a slew of different factors that affect interest rates, the movement of the 10-year Treasury bond yield is said to be the best indicator to determine whether mortgage rates will rise or fall. But why?
Though most mortgages are packaged as 30-year products, the average mortgage is paid off or refinanced within 10 years, so the 10-year bond is a great bellwether to measure interest rate change. Treasuries are also backed by the “full faith and credit” of the United States, making them the benchmark for many other bonds as well.
Additionally, 10-year Treasury bonds, also known as Intermediate Term Bonds, and long-term fixed mortgages, which are packaged into mortgage-backed securities (MBS), compete for the same investors because they are very similar financial instruments.
However, treasuries are 100% guaranteed to be paid back, while mortgage-backed securities are not, for reasons such as payment default and early repayment, and thus carry more risk and must be priced higher to compensate.
How will I know if mortgage rates are going up or down?
Typically, when bond rates (also known as the bond yield) go up, interest rates go up as well. And vice versa. Don’t confuse this with bond prices, which have an inverse relationship with interest rates.
How Are Mortgage Rates Determined?
One of the most important aspects to successfully obtaining a mortgage is getting the best interest rate. For most homeowners, this means securing the lowest, fixed interest rate (no negative amortization!).
Many homeowners rely on their bank or mortgage broker to secure their interest rate, often without researching mortgage lender rates or inquiring about how they move. Whether you’re interested in rates or not, it’s wise to get a better understanding of how mortgage rates move, and why.
After all, a change in rate of a mere .125% to .25% could mean thousands of dollars in savings each year.
So how are mortgage rates determined?
Although there are a slew of different factors that affect interest rates, the movement of the 10-year Treasury bond yield is said to be the best indicator to determine whether mortgage rates will rise or fall. But why?
Though most mortgages are packaged as 30-year products, the average mortgage is paid off or refinanced within 10 years, so the 10-year bond is a great bellwether to measure interest rate change. Treasuries are also backed by the “full faith and credit” of the United States, making them the benchmark for many other bonds as well.
Additionally, 10-year Treasury bonds, also known as Intermediate Term Bonds, and long-term fixed mortgages, which are packaged into mortgage-backed securities (MBS), compete for the same investors because they are very similar financial instruments.
However, treasuries are 100% guaranteed to be paid back, while mortgage-backed securities are not, for reasons such as payment default and early repayment, and thus carry more risk and must be priced higher to compensate.
How will I know if mortgage rates are going up or down?
Typically, when bond rates (also known as the bond yield) go up, interest rates go up as well. And vice versa. Don’t confuse this with bond prices, which have an inverse relationship with interest rates.
10-year bond yield up, mortgage rates up.
10-year bond yield down, mortgage rates down.
To get an idea of where mortgage rates will be, bond investors typically use a spread of about 170 basis points, or 1.70% above the 10-year bond yield to estimate interest rates. So a bond yield of 4.00% plus the 170 basis points would put mortgage rates around 5.70%. Of course, this spread can vary over time, and is really just a quick way to ballpark mortgage interest rates.
There have been, and will be periods of time when mortgage rates rise faster than the bond yield, and vice versa. So just because the 10-year bond yield rises 20 basis points doesn’t mean mortgage-backed securities will do the same. In fact, MBS could rise 25 basis points, or just 10 points, depending on other market factors.
What other factors move mortgage rates?
Factors such as supply come to mind. If loan originations skyrocket in a given period of time, the supply of mortgage-backed securities will rise beyond the demand, and prices will need to drop to become attractive to buyers.
Timing is also an issue. Though bond prices may plummet in the morning, and then rise by the afternoon, mortgage rates may remain unchanged. That’s because sometimes the bond movement doesn’t always make it down to the wholesale markets, or simply because it takes more time to do so.
Inflation also greatly impacts mortgage rates. If inflation fears are strong, interest rates will rise, but in times when there is little risk of inflation, mortgage rates will most likely fall.
Economic activity impacts mortgage rates.
Mortgage rates are more susceptible to economic activity than treasuries, mainly because the average consumer or homeowner may lose their job or be unable to make their mortgage payment, while the US government typically doesn’t miss payments.
For this reason, jobs reports, Consumer Price Index, Gross Domestic Product, Home Sales, Consumer Confidence, and other data on the economic calendar can move mortgage rates significantly.
And don’t forget the Fed. When they release “Fed Minutes” or change the Federal Funds Rate, mortgage rates can swing up or down depending on what their report indicates about the economy. Generally, a growing economy leads to higher mortgage rates and a slowing economy leads to lower mortgage rates.
As a rule of thumb, bad economic news brings on lower rates, and good economic news makes mortgage rates climb.
The situation is a lot more complicated, so consider this is an introductory lesson on a very complex subject. And remember, the par mortgage rates you see advertised don’t take into account any pricing adjustments or fees that could drive your actual interest up or down considerably.