Mortgage rates rise and fall day after day, week after week. Sometimes mortgage rates can change even during the course of one single business day and in times of extreme volatility, rates can move up and down several times in just one day. A common misperception is that the Fed sets interest rates. While they do set certain types of rates, they can only indirectly affect mortgage interest rates. Instead, mortgage rates are directly related to market fluctions in mortgage backed securities.
What are Mortgage Backed Securities?
Mortgage backed securities (MBS) are bonds that are backed, or secured, by pools (bundled groups) of mortgage loans. As a mortgage company issues a mortgage loan, the lender has a choice to keep that loan in their portfolio and collect the principal and interest payments, or sell the loan.
By selling the loan, the lender then frees up additional capital to make even more loans to their customers. This is what an overwhelming majority of banks choose to do. Banks usually only hold/own a small percentage of the mortgages they originate.
The mortgage loans they choose to sell can be sold to a government sponsored enterprise, or a GSE, such as Fannie Mae or Freddie Mac. Government mortgages like FHA or VA loans are sold to the Government National Mortgage Association, or Ginnie Mae. These GSEs then bundle, or “pool” these loans together and sell them again to individual investors. These “pools” are mortgage backed securities.
Investors and Mortgage Backed Securities
Just like any investor, those who invest in mortgage backed securities are looking for profit. In a weak or uncertain economy, profit can be elusive. That’s where mortgage backed securities come in.
Each time a homeowner makes a mortgage payment to the lender, the interest payments pass through to the investor holding the mortgage backed security. The investor collects the interest on the loan, less associated costs such as fees for collecting the monthly payments and managing the flow of interest payments.
MBS provide a guaranteed return, providing a level of safety that a stock cannot. MBS yields (earnings) are typically lower than investing in the stock market over time but they’re a lot more secure. Investors know what they’re getting.
As more and more investors flock to the safety of bonds in general, there is an increase in demand. As with any increase of demand, this causes an increase in the price because more investors are bidding for the same bond. With bonds, as the price of a bond goes up, the interest returned on that bond falls.
In times of economic uncertainty, more and more investors turn to mortgage backed securities and other bonds as a safe investment vehicle, keeping interest rates low. When the economy recovers and investors seek greater returns, money will be pulled out of mortgage backed securities and invested in stocks.
Essentially, when the economy is strong, mortgage interest rates will be higher. When the economy is soft, rates will be lower.
That’s a mortgage backed security. So how does that affect your interest rate?
How Banks Set Mortgage Interest Rates
Each day as lenders begin to issue their mortgage rates, they pay attention to the corresponding mortgage bond associated with the loan program. For instance, a 30 year conventional mortgage will be priced against a Fannie Mae 30 year bond, commonly listed as FNMA 30 yr. A 15 year FHA mortgage is associated with a GNMA 15-yr bond, and so on. All lenders who approve both conventional loans and government-guaranteed loans such as VA, FHA and USDA loans all refer to the very same set of indices each day and set their interest rates accordingly.
Each bank will set their interest rates a little differenty based on these indices, desired profit margin, and how competive they want to be. That’s why one bank may offer slightly different rates than another bank.
Actions of the Fed
One of the many tasks the Federal Reserve, or the Fed, is to help control the cost of money. Banks borrower from each other primarily, but as a last resort, banks can also borrow directly from the Fed. The rate at which banks borrow from the Fed is the Discount Rate.
The Fed has the power to change the Discount Rate. Although the Discount Rate and mortgage rates aren’t tied together, they often move in the same general direction. If the Fed raises the Discount Rate, it may be an indication that mortgage rates may be set to rise.
Another way the Fed can impact interest rates is to buy mortgage backed securities. Currently the Fed is buying mortgage backed securities at the rate of about $40 billion per month. This significant amount of buying props up the demand and price of the mortgage backed security, which in turn keeps mortgage rates low. If and when the Fed announces an end to this buying program, mortgage interest rates will likely rise, perhaps dramatically.
Treasuries and Mortgage Backed Securities
While mortgage backed securities and Treasuries are similar, they’re not the same. Both provide a guaranteed return to their investors but are they are in fact different investments. Yet a common misperception is that mortgage rates are tied to the 10-year Treasury and that’s not actually the case. However, the returns on a 10-year Treasury and mortgage backed securities do in fact follow similar paths. Why?
Historically, mortgages last about seven years, despite the 15 year or 30 year term legally assigned to them. This shorter term is because the owner typically refinances or sells the property within seven years of opening the mortgage. Both these actions retire the existing loan. The Treasury with the closest term to seven years is the 10 year Treasury and provides similar yields that a mortgage backed security will.
Rates on Treasuries can be easily tracked by consumers on any financial website or newspaper but rates on private mortgage backed securities are harder to find. Typically only financial institutions, mortgage companies, banks and institutional investors have access to live quotes on mortgage backed security prices. That’s why consumers sometimes track the 10 year Treasury yields to get an idea about how mortgage rates are performing.
MBS Summary and Wrap Up
Hopefully this quick MBS guide sheds some light on what drives mortgage rates, and what doesn’t. In short, mortgage rates are driven by market forces.
For this reason, it’s almost impossible to lock in your loan on the very lowest day in history. It’s about as hard as buying a particular stock just before it takes off. The market is just too unpredictable.
The important thing is that you lock in a rate that provides you with a monthly housing payment that is within your budget. If you can accomplish this goal, you’ve done well.
Check back for our weekly Interest Rate Update at MortgageRefinanceRates.org to keep up with what’s going on in the world of mortgage interest rates.