American Flag“Mortgage rates are at near-historic lows.” “Lock now before the Fed raises interest rates.” If you’re in the market for a mortgage, you may be hearing these messages often with little or no idea how these rates are set. As far as you’re concerned, your lender could be pulling these numbers out of thin air.

Trust me, these numbers are based on very real economic factors, most notably movements in the bond market. Movements in bonds are affected by the state of the economy, events around the globe and – when it wants to get involved – the U.S. government.

What’s that? You want a little more than my word for it? In order to see how these things interact, you need to understand a little bit about economics and a little bit about how the sausage is made in the mortgage business.

Let’s take the mortgage piece first.

A (Short) Primer on the Mortgage Business

Let’s imagine for a moment that Jane Smith has just closed on a 30-year fixed-rate loan. Most lenders don’t hold on to your loan for 30 years. Lenders need new capital in order to make new loans to incoming clients. They can’t wait for several years of payments to come in, so they’ll often sell your loan on a secondary market.

Here’s how it works:

Your loan is usually insured by a government-sponsored enterprise (GSE) like Fannie Mae or Freddie Mac. In the case of FHA and VA loans, the insurance is provided through departments run by the U.S. government. The insurers assume the risk should you default on your loan. This insurance enables liquidity in the bond market, allowing loans to be bought and sold as mortgage-backed securities (MBS) by anyone without the exposure to risk that comes with potential foreclosures. Each of these agencies have very specific requirements for the types of loans they will insure. This is why you see variation in things like the credit score and amount of down payment required to qualify for a specific loan type.

The agencies then turn around and package the individual loans into MBS that are sold to investors in the bond market. The MBS are made up of similar loans. For example, Jane Smith’s loan might be included in a group with 10 other loans that are all 30-year fixed-rate mortgages taken out by clients with 720+ credit scores. The MBS are then sold to interested investors in the bond markets. It’s this interaction in the markets that enables the governments (both here and abroad) to influence rates.

Bond basics

The character of James Bond first appeared in Ian Fleming’s 1953 novel “Casino Royale.” Since then, his adventures have spawned numerous books and Hollywood adaptations starring Sean Connery, Pierce Brosnan and Daniel – oh, wrong bond.

People buy (investment) bonds because, unlike stocks, you know what your return is going to be at the end of the term rather than living at the mercy of day-to-day fluctuations in the stock market. How good the return is will depend upon how much you paid for the bond, but (assuming complete financial collapse is avoided) you will get something back out of it.

“From Russia with Love”: Global Impact of Bond Markets

Bond markets and, in turn, mortgage rates are affected by events taking place all over the world. Earlier this year crude oil prices were in a bit of a freefall due to large amounts of oil flooding the market. This caused investors to sell off some of their investments in oil companies and reinvest in the U. S. bond market, which is considered something of a safe haven. One particular source of this bond market love was investors who were fleeing Russian investments in the face of a collapsing ruble due in part to low oil prices.

This caused the 10-year treasury, a key predictor of U.S. mortgage rates to lower its yield, or promised return. The yield drops when it doesn’t have to be so high in order to get people to buy. The drop in oil prices actually caused mortgage rates in the U.S. to fall quite a bit during this period.

How Governments Can Influence Mortgage Rates

Governments have two different types of policy tools they can use as jumper cables to kick-start an economy: fiscal policy and monetary policy. Monetary policy has the impact on mortgage rates. The difference between the two can often be confusing though, so it might help to take a moment and explain.

Fiscal Policy vs. Monetary Policy

When economists refer to fiscal policy, they mean the things the government can do in terms of spending to help the economy. Fiscal policy manifests itself in two ways. In the first, the government can lower taxes in order to encourage citizens to invest the money they save on taxes on goods and services. In the second strategy, the government can increase its own spending on goods and services. The hope here is that businesses will hire more workers in order to keep up with the increased orders from the government.

Monetary policy, on the other hand, refers to the ability of the government to influence interest rates through its control of the money supply. By putting more money in the market, central banks (like the Federal Reserve in the U.S.) lower interest rates because the cost of obtaining money is cheaper. This encourages investment. Removing money from the market makes interest rates go up, encouraging people to save.

Lowering Interest Rates

If the Federal Reserve feels that interest rates have become high enough that people don’t want to borrow money for investment in the economy, it can lower the rate it charges banks to get money. The idea is that the savings are passed on to the bank’s borrowers in the form of lower interest rates. This should boost borrowing and get the economy going.

What happens when bringing rates as low as possible, effectively zero for banks, doesn’t get things moving along as well as the Fed would like?

A Little Help from Q(E)

When James Bond is in a tight spot, he can always rely on a gadget from Q to get him out of trouble. When the Federal Reserve was unhappy with the way the economy was working in 2008–09, it turned to QE.

QE stands for quantitative easing and it works like this. The government introduces new money into the markets by buying various bonds. The goal is that banks take the money earned from the sale of these bonds to the Federal Reserve and use it to make new loans, further lowering interest rates.

One type of bond that the government has bought a lot of during its QE period is MBS. With so much more MBS being bought up, the offered yield doesn’t have to be as high and mortgage rates go down. One strong predictor of mortgage rates is the 10-year U.S. Treasury yield. When the bond yield for this treasury is down, rates are down and vice versa.

I’ve included the visual below so you can see the effect that the U.S. QE program has had on mortgage rates.

graph

Since the program ended in October 2014, the Fed has kept short-term interest rates near zero, although that’s expected to change later this year. When the rise hits, mortgage rates will go up.

It’s important to note that the mortgage rate being referred to here is only the absolute baseline rate you could get. Your personal rate would depend on factors such as the type of loan, your down payment, your credit score and the number of prepaid interest points you pay.

That concludes today’s lesson on how mortgage rates are set. Don’t worry! There’s no quiz. If you have a question, you don’t even have to wait for my office hours. Just leave us a note in the comments!

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