Mortgage rates are definitely on the rise, but do you really understand why? Without a little bit of background in the financial markets, it can seem like the rates are set based on a whim.
Lenders will have varying pricing based on their costs, and you should definitely shop around. Still, at a market level, there’s certainly a method to the madness that defines how rates are set.
The goal of this blog post is to explain the current rate environment we’re in and what it means if you’re in the market for a mortgage, but first, let’s go over a little bit about how the mortgage market works.
The Mortgage Bond
When you get a mortgage, it’s possible that the lender could decide to hold on to the loan for the entire term and collect payments every month until the loan is paid off. However, that’s a slow process, and lenders typically want to get capital more quickly so they can make more loans and help more clients.
In order to gain quicker access to capital, mostly loans are sold on the secondary bond market to outside investors within a matter of months after they’re closed. Often, the client doesn’t notice the difference because lenders have the option of continuing to service the loans. This means they collect the payments on behalf of the investors. Quicken Loans retains servicing on the vast majority of its loans.
In order to provide investors with some measure of assurance, the loans are typically backed by investors like Fannie Mae, Freddie Mac, the FHA, the USDA or the VA. In order to qualify for these loans, people need to meet the requirements for both finances and the property they’re buying.
Once the loan is backed by one of these agencies, it’s packaged into something called a mortgage-backed security (MBS). One MBS might have $10 million worth of people’s mortgages in it, but the key is that they share common characteristics.
As an example, one MBS might contain a bunch of loans from the FHA that have 30-year terms and borrowers with credit scores between 640 to 660 with down payments of 5% or less.
Through their buying and selling of these bonds, market investors determine what the going price, or yield, on the MBS should be. If there is high demand for mortgage bonds (maybe the stock market is down and investors want safer fixed yield assets), the rate of return doesn’t have to be as high, and mortgage rates go down. If demand for bonds drops (the stock market is higher or inflation is rising quickly), the return has to be higher, and mortgage rates go up.
The U.S. government has up until recently played a role in keeping mortgage rates low by buying up a ton of mortgage bonds in hopes of keeping borrowing rates low and kick-starting the economy by encouraging investment. However, if you keep rates low forever, you risk inflation going up to sky-high levels because the money that people save is worth less when interest rates are low. The Federal Reserve has recently stopped buying and started selling its mortgage bond portfolio back into the market.
The Treasury as an Interest Rate Oracle
No one can reliably predict where interest rates are going to go from hour to hour, let alone day to day or week to week. With that said, there is at least one indicator that will tell you the direction mortgage rates might be pointing: the 10-year U.S. treasury bond.
Typically, the 30-year fixed mortgage rate may average around 2% higher than the 10-year treasury yield, give or take a few tenths of a percentage point, given the way the yield curve is behaving. What’s the reasoning behind this?
The 10-year U.S. treasury is considered a reliable predictor of overall demand in the bond market. If the yield is low, people want safer assets and are buying more bonds, including mortgage bonds. When it’s higher, people are buying fewer bonds, which tends to correlate with higher mortgage rates.
So What’s Happening Now?
The 10-year treasury hit the highest level it’s seen in four years recently, coming in above 2.9%. What’s causing traders to flee the bond market?
The Federal Reserve has steadily been raising short-term interest rates for a while now from near 0% to their current level between 1.25% – 1.50%. Although this doesn’t have a direct effect on longer-term rates, changing the rate at which banks can borrow money overnight makes getting capital more expensive for the bank. This cost is typically passed on to clients.
The Fed only raises rates if it’s concerned about the potential for increasing inflation and thinks the economy can handle an interest rate rise. Investors also expect upcoming inflation reports to show prices are rising at a more rapid pace. If that happens, the Fed will have to raise rates in an attempt to keep inflation in check. When that happens, rates for all sorts of loans, including mortgages, go up.
Investors might also move from bonds into stocks or other higher risk investments because bonds don’t tend to generate as much return in an environment of rapidly rising inflation.
Rates are still pretty good right now, sitting in the 4% range. However, no one can say for sure how long it will stay that way. If you’re looking to buy a home or cash in some of your existing equity to boost their retirement fund or do a home improvement project, there’s never been a better time to lock your rate than right now.
If you’re in the market for a mortgage, you can get a preapproval to purchase or a full refinance approval online in minutes through Rocket Mortgage® by Quicken Loans. If you would rather get started over the phone, you can speak with one of our Home Loan Experts by calling (888) 980-6716. Feel free to leave your questions for us in the comments below.
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