How Are Mortgage Rates Determined?
Many people believe that interest rates are set by lenders, but the reality is that mortgage rates are largely determined by what is known as the Secondary Market.
The secondary market is comprised of investors who buy the loans made by banks, brokers, lenders, etc. and then either hold them for their earnings, or bundle them and sell them to other investors.
When the secondary market sells the bundles of mortgages, there are end investors who are willing to pay a certain price for those loans.
That market price of those Mortgage Backed Securities (MBS) is what impacts mortgage rates.
Typically, investors are willing to accept a lower return on mortgage backed securities because of their relative safety compared to other investments.
This perception of safety is due to the implied government backing of Fannie Mae and Freddie Mac and the fact that the Mortgage Backed investments are based on real estate collateral.
So, if the loan defaults there is real property pledged against potential losses.
In contrast, other investments are considered more risky, specifically stocks which are based on earnings and profit vs real property. The movement between the two investment vehicles often dictates mortgage rates.
Why Do Mortgage Rates Change?
- Mortgage rates fluctuate based on the market’s perception of the economy.
- Stocks are considered riskier investments, and therefore have an expected higher rate of return to compensate for that risk.
- When the economy is thriving, it is presumed that companies will perform better, and therefore their stock prices will move higher.
- When stock prices move higher – MBS prices generally move lower. Mortgage Backed Securities, however, thrive when the economy is perceived as not doing well.
- When investors forecast a faltering economy, they worry that the return on stocks will be lower, so they frequently engage in a ‘flight to safety’ and buy more secure investments such as Mortgage Backed Securities. Mortgage rates are actually based on the yield of those Mortgage Backed Securities.
- Bonds are sold at a particular price based on their value in relation to other available investments. When a bond is sold it yields a certain return based on that original purchase price. As the prices of the MBS increases because investors seek their safety, the yield decreases.
- Conversely, when investors seek the higher returns of stocks and the MBS are purchased in lesser quantities the price goes down. The lower price results in a higher yield, and this yield is what determines mortgage rates.
How Would I Know if Rates are Expected to Go Up or Down?
- When the economy is growing or is expected to grow, stocks will likely become the more favored investment.
- When investors buy more stocks, they purchase fewer MBS, which drives the price down.
- When the price of the MBS is lower, the yield increases.
- Since mortgage rates are based on the yield of the 30 Year MBS, you would expect rates to increase in this environment.
- When the economy appears to be slowing or is doing poorly, investors typically move their money out of the stock market and into the safety of the MBS.
- This drives the price of these investments higher, which results in a lower yield.
- Since mortgage rates are based on the yield of the 30 Year MBS, you would expect rates to decrease in this environment.
Since these market variables and expectations change multiple times as economic reports are released throughout the course of a week, it is not uncommon to see mortgage rates change several times a day.
Understanding how rates move is not necessarily as important as having a loan officer that is equipped with the technology and professional services to track and stay alerted at the precise moment rates make a move for the better or worse.