As of June 25, 2018, we’ve made some changes to the way our mortgage approvals work. You can read more about our Power Buyer ProcessTM.
If you’re in the market for your first home, you probably feel inundated with all sorts of messaging. “Rates are up a bit, but still low.” “Lock your rate now before rates go up.” We share this type of news all the time. After all, we want to make sure you get the best rate possible.
Most mortgage lenders do an effective job of telling you where rates are, but where do rates actually come from? It’s tempting to think of them as being conjured out of thin air, but that’s not the case.
To really understand how this works, you need to have a general idea of the interplay among the Federal Reserve, the financial markets and your mortgage. But before we do that, let’s discuss what the Federal Reserve actually does and how they do it.
The Federal Reserve: What It Does and How
The Federal Reserve takes on a variety of tasks in terms of monitoring the economy, but one of its most important jobs is fostering economic conditions that promote low unemployment and stable prices.
The main way it does this is to control short-term interest rates. Every month or two, the Federal Reserve’s most well-known committee, the Federal Open Market Committee (FOMC), gets together and makes a decision on how much interest banks should have to pay on funds that are borrowed overnight.
If it costs a lender more in order to borrow the funds it needs to lend to you for things like your car, a mortgage or a personal loan, they’ll eventually have to pass the cost on, and consumer interest rates go up.
When rates are low, it’s more cost-effective for consumers to borrow funds. This can be good for the economy because they have more funds to buy all kinds of items. This also encourages businesses to expand, which leads to more hiring.
So why not keep rates low all the time? Anyone who has ever eaten one too many cookies knows that you can have too much of a good thing. The economy is the same way. If it’s too easy to get our hands on money, it can lead to high inflation, which causes prices to rise too quickly.
The Federal Reserve’s primary responsibility is to make sure that these things stay in balance.
Sometimes the Federal Reserve thinks the economy needs a little extra boost. The last time this happened, they turned to something called quantitative easing. Let’s talk a bit about that and why the mortgage market is still seeing the effects of the program.
Around 2008, the American economy was having a hard time. One of the reasons for this was a crash in the housing market brought on by falling home values. In order to encourage people to keep buying things, including houses, the Fed immediately enacted a policy of slashing short-term interest rates so that banks could pass the borrowing savings on to consumers. But interest rates can only fall so far, and an extra boost was needed.
The Federal Reserve chose to buy a ton of bond market assets in order to drive down interest rates in a program of quantitative easing. What does any of this have to do with mortgage rates? Let’s take one more step back and take a look at the mortgage market.
All About Mortgage-Backed Securities
Let’s say you just closed your loan with Quicken Loans. All of your paperwork is in order, and you meet all the qualifications to have your loan backed by one of the major mortgage backers – Fannie Mae, Freddie Mac, the FHA or the VA, for example. This guarantee is insurance for investors that even if the worst happens and you default on your loan, one of those entities will retrieve as much money as possible on the mortgage-backed security (MBS) investor’s behalf.
Once your loan has received this stamp of approval, it’s ready to be packaged into an MBS. These securities are nothing more than pools of similar loans that investors can buy into. Let’s say you had a 30-year loan with a down payment of 5% and a credit score of 700. Your loan would be placed in a package along with other similar loans and made available to other MBS investors to buy on the open market.
MBS can be bought by anyone, from individual investors to mutual fund and retirement fund managers. If your 401(k) manager happens to invest in mortgage bonds, you might even own a little piece of your own mortgage without even knowing it.
These MBS are bought and sold on the bond market. If there’s a lot of demand for mortgage bonds, the return on them doesn’t have to be as high, and mortgage rates go down. If mortgage bonds are being sold off (maybe Americans think the economy is getting better and are pumping more money into the stock market), returns have to get higher to attract buyers, and rates go up.
So where does the Federal Reserve fit into all of this? I thought you’d never ask.
The Federal Reserve and MBS
Remember the quantitative easing program I mentioned? The Federal Reserve bought a whole lot of mortgage bonds when the economy was struggling. These are made up of fixed-rate Fannie Mae, Freddie Mac, FHA and VA loans. In fact, they’re currently the biggest purchaser of MBS in the bond market. Taken in tandem with low short-term interest rates, this has kept mortgage rates very low.
The Fed has its reasons for encouraging people to invest in housing. According to data from the U.S. Census Bureau compiled by the National Association of Home Builders, residential investment, including construction of new single- and multi-family homes, accounts for between 3% and 5% of U.S. gross domestic product (GDP), which is the most widely used metric of economic growth.
Furthermore, when you factor in the cost of rent and utilities and the equivalent rent and utility costs paid by homeowners, housing contributes an additional 12% to 13% to GDP on an annual basis.
Once you understand the economic impact, it can be easy to see why the Federal Reserve has about $1.77 trillion worth of MBS on its current balance sheet. The current policy of the Fed is to reinvest the proceeds each time one of its MBS holdings matures into more MBS. This has the effect of helping keep mortgage rates down.
Recently, there’s been talk that the Fed may want to sell its holdings to make more room on the balance sheet. There are two reasons for this.
The first reason is that the Federal Reserve only takes measures like quantitative easing and the bond buying associated with it in times of extraordinary economic stress. While the economy will probably never be perfect, we’re certainly in a pretty good place now.
The other reason to unload the mortgage bonds is that it gives the Fed more options in the event that the economy needs another jumpstart in response to a future crisis. In essence, the Fed would have one more card to play.
Bottom Line for Buyers
If you’re looking at buying a home right now, there are a couple of things you need to know.
The Federal Reserve has raised short-term interest rates once already this year. Furthermore, they project potential future interest rate increases on something called the dot plot. The median member of the FOMC sees short-term interest rates as being between 1.25% and 1.5% by the end of the year. This would mean two more interest rate increases.
When short-term interest rates increase, it’s reasonable to expect rates for things like mortgages to increase as well if the price of bonds goes up.
In addition, if the Federal Reserve starts to sell some of its investments in MBS, rates are likely to go up as the Fed exits the market. Unless a buyer – or several, more likely – wanted to step in and buy the high volume of mortgage bonds sold, yields would be pushed higher in order to attract buyers, and rates would move up, too.
If you’re looking to buy your first home, rates are around 4.5% right now. While this isn’t an all-time low, it’s pretty far down there when you look at it in the context of history. In the early 1980s, rates were briefly as high as 16.63%. Even as recently as 2003, they were in the high 5% range. With that in mind, today’s rates look really good.
If you’re interested in getting into your first home while you have the opportunity to take advantage of these low rates, you can get preapproved online through Rocket Mortgage or by calling (800) 785-4788 to speak with one of our licensed Home Loan Experts. We would love to talk to you.
I know this stuff is complicated. If you have any questions, leave them in the comments, and we’ll do our best to provide straightforward, clear answers.
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