How Do Bond Rates Affect Mortgage Rates?

Whenever you hear people trying to predict whether mortgage rates will go up or down in the future, you may hear them reference bond prices as part of the discussion. But how are bonds and mortgage rates connected? And how do bond rates affect mortgage rates?

Bond prices and mortgage rates often move in opposite directions because when bond prices rise, their yields fall – and mortgage rates tend to follow bond yields. Understanding the nuances of that relationship – as well as factors such as mortgage-backed securities – can get confusing. We’ll explain how the bond market works, how it affects mortgage rates and, most important, what all that means for borrowers.

How Do Bonds Work?

To answer the question “How do bond rates affect mortgage rates,” let’s first explore how bonds work.

For starters, bonds differ from stocks; they function more like a loan. While stocks are ownership shares in a company, bonds let you loan money to a company or a government. Investors lend money to a government or corporation at a set interest rate for a predetermined period. The borrower then repays the investor interest in addition to the original face value of the bond.

A common reference point in financial markets is U.S. Treasury securities, such as Treasury notes and Treasury bonds. A Treasury bond is essentially a loan to the U.S. government for which an investor receives a fixed interest payment.

For example, let’s say you buy a $1,000 Treasury bond directly from the U.S. Treasury Department with a 5% annual fixed interest rate and a 10-year maturity. That means the U.S. government will pay you $50 in interest each year.

Those interest payments (also known as “coupon” payments) don’t change over the life of the investment, and the government also promises to repay the $1,000 principal after 10 years.

Corporations can also offer their own bonds with similar terms. In such cases, you lend money to the company, and it will also pay you interest on the loan and repay the principal at maturity.

The main difference between corporate bonds and Treasury bonds is the risk you assume. Corporations are more likely than the government to fail to repay investors, so that heightened risk often translates into higher potential returns for you. 

Understanding Mortgage-Backed Securities

Another “loan”-based investment product that plays a part in this scenario is a mortgage-backed security (MBS).

An MBS is a group of mortgages packaged together by a bank or other financial institution and then sold to investors, who receive a portion of the principal and interest payments on the mortgage loans held within the group. In many cases, lenders sell mortgages to a government-sponsored enterprise (GSE) like Fannie Mae or Freddie Mac, which package many loans together into mortgage-backed securities that are sold to investors

MBSs compete with Treasury and corporate bonds in the secondary market by typically offering slightly higher returns for investors, since the underlying mortgages carry some risk that homeowners might default on their payments.

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How Does The Bond Market Affect Mortgage Rates?

Many factors influence mortgage interest rates, including inflation and economic growth. The bond market also plays a part – particularly bond prices and yields.

A bond’s yield is the percentage return that an investor actually earns based on the bond’s current market price – not its original issue price. (It’s worth noting that a bond’s interest rate is not necessarily the same as its yield.)

Bond prices and bond yields also have an inverse relationship: When bond prices rise, their yields fall, because investors are now paying a higher price for that same return.

Mortgage-backed securities compete with Treasury and corporate bonds for investors, so when demand for bonds increases, demand for MBSs often increases as well. And as the price of MBSs increases, the cost of funding mortgages for lenders decreases. Lenders can then pass those savings on to borrowers in the form of lower mortgage rates. 

Mortgage rates tend to move in the same direction as the yield on the 10-year Treasury note, which is widely used as a benchmark for long-term interest rates. When the 10-year Treasury’s yield rises, mortgage rates tend to increase. When the yield on the 10-year Treasury falls, mortgage rates tend to fall as well.

What does that mean for hopeful buyers like you? If you want to secure a mortgage with a lower interest rate, you can root for bond prices to go up. This will result in yields falling, which means it’s also likely that home loan rates will fall.

Some types of mortgages are impacted by the bonds market more than others; for example, bond prices primarily affect fixed-rate mortgage rates.That’s because lenders tie fixed mortgage rates to bond rates. Adjustable-rate mortgages (ARMs) are typically tied to short-term interest rate indexes, which are influenced by monetary policy from the Federal Reserve.

Why Bonds And Mortgage Rates Matter

Why is it helpful for a home buyer to understand the relationship between bonds and mortgage rates? Understanding this dynamic can help you make better informed decisions about your own lending options.

While you can’t control the bond market or interest rates, you can compare mortgage rates across multiple lenders and choose a lender with a more competitive rate and loan terms. Your mortgage rate will impact the total cost you pay over the life of your home loan. Applying for a home loan when mortgage rates are low can save you money on lending costs.

Your Financial Situation Also Impacts Your Mortgage Rate

Your current financial situation also plays a part in your mortgage rate. Factors like your income, credit score and debt-to-income ratio (DTI) can affect the mortgage rate you qualify for when applying for a home loan.

Having a lower DTI and a good credit score may help improve your chances of being eligible for a mortgage with a lower interest rate. If you’re unsatisfied with your credit standing, taking steps to improve it and reduce your debt before applying for a mortgage can be beneficial.           

FAQ

Here are some answers to commonly asked questions about the connection between bonds and mortgage rates:

The Bottom Line: It Pays To Understand The Relationship Between Bonds And Mortgage Rates

How do bond rates affect mortgage rates? Typically, when bond prices go down, mortgage rates tend to increase. And when bond prices go up, mortgage rates are likely to decrease.

Since the 10-year Treasury yield is a widely used benchmark for mortgage rates, watching that metric can help you gauge how mortgage rates might trend. If you’re looking to apply for a fixed-rate mortgage, it can be helpful to track changes to the bond market so you can make a more informed lending choice.

Natasha Etzel

Natasha Etzel is a financial writer with over a decade of experience. She has covered various financial topics, including mortgages, personal loans, home equity loans, debt consolidation, and refinancing. She writes for financial companies, including mortgage lenders, and various publications, including NerdWallet, Newsweek, The Motley Fool, and more.

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