A Beginner’s Guide To The Mortgage Market: What It Is And How Affects Rates
If you’re looking to purchase or refinance a home, you’re probably being exposed to a whole range of information, and you may have a few questions that the average person wouldn’t think about: How are mortgage rates determined? What is it exactly that mortgage investors like Fannie Mae, Freddie Mac and the VA do? Finally, after your loan closes, what’s mortgage servicing?
That’s a lot to cover. Let’s jump into some of the basics of the mortgage market.
What Is The Mortgage Market?
The mortgage market is the underlying structure that supports home lending through mechanisms that help with the free flow of funds so that lending can continue. While that definition covers what it is, it’s necessary to break things down a little bit further.
Let’s take this from the beginning. A mortgage is any loan that pledges a piece of real estate as collateral. You can have mortgages associated with buildings and pieces of land, but the everyday consumer is probably most familiar with the mortgage as a home loan.
The mortgage market is split into two main components: a primary mortgage market and a secondary mortgage market. The primary market is the one consumers interact with. In this market, you obtain a mortgage through a bank or a specialized mortgage originator.
What Is The Secondary Mortgage Market?
One of the weaknesses of the primary mortgage market comes down to the structure of mortgage loans themselves. They’re designed to be long-term investments. For this reason, if banks and mortgage originators held onto loans for the life of the term, they would have to wait up to 30 years to be fully paid back. This would limit the amount of funding available for people to get homes.
To deal with this problem, a robust secondary market of mortgage investors exists.
The secondary mortgage market enables investors to buy mortgage-backed securities (MBS), entitling them to principal and interest from mortgage payments. These MBS are often made available by major mortgage investors like Fannie Mae, Freddie Mac, the FHA and VA. These agencies provide investor protection, by guaranteeing future payments in the event of default.
Understanding Mortgage Loans
Before we get further into the mortgage market, it probably makes sense to have an overview of the types of loans available to borrowers in the primary market. This will just be a brief touch point. For more details, feel free to check out our article on types of loans.
Broadly, there are two major types of mortgage: conforming and nonconforming loans. Let’s break these down just a bit.
Conforming loans are those from Fannie Mae and Freddie Mac. These are also called conventional loans. While they require a credit score that’s a bit higher, they have several advantages including down payments as low as 3% and removal of mortgage insurance with a 20% down payment or equity amount.
Nonconforming loans include jumbo loans that rise above conventional loan limits as well as those backed directly by government agencies such as the FHA and VA.
Jumbo loans require higher down payments and credit scores. Different lenders may have their own policies.
The advantage of FHA loans is that you can qualify even if you have some blemishes on your credit. You may be able to qualify with a FICO® Score as low as 500 if you have a 10% down payment, but most lenders require a minimum median FICO® of 580 with a 3.5% down payment and a very low housing expense ratio and debt-to-income ratio (DTI). However, DTI requirements can be more flexible than some other loans if you have a credit score above 620.
VA loans offer lower rates than most other major loan types and have no required down payment. To qualify, you have to be an eligible active-duty servicemember, reservist, member of the National Guard, veteran or surviving spouse receiving dependency and indemnity compensation. Instead of mortgage insurance, there’s a one-time funding fee that’s waived in some circumstances.
The above options include many of those covered by private mortgage originators. Banks may have other options.
Understanding Mortgage Rates
When shopping around for mortgage rates, you may be inclined to think that lenders set these things arbitrarily. However, there are 2 big facets to determining the mortgage interest rate: market conditions and your personal financial profile.
Base Market Rates And The Federal Reserve
Dating back to its original mandate from Congress, the Federal Reserve is the central bank of the United States. This means it has a variety of responsibilities, including overseeing banks as a whole and setting certain financial policy regulations. But perhaps the most important role it plays from a consumer perspective is in the setting of short-term interest rates.
When the Fed’s Open Market Committee (FOMC) meets to determine what the Fed Funds Rate should be at any given time, it has a couple of key goals:
- Achieving maximum employment
- Maintaining stable prices (i.e., keeping inflation at bay)
The Fed has a bit of a balancing act here, because those goals sometimes run in competition with each other. To achieve the highest possible rate of employment, you might choose to keep interest rates low, because cheaper borrowing can stimulate businesses to invest. This can lead to more hiring as well as more money spent on goods and services, which can have a knock-on effect and help still more businesses prosper.
However, if the cost of borrowing funds is too low, this also tends to mean that the money you have saved in the past is worth less than if higher borrowing costs made funds scarcer. If your money isn’t worth as much, prices can go up quickly, as you need to part with more money to receive the same value.
It should be noted that a little bit of inflation can be a good thing, since the threat of rising prices can encourage people to buy now rather than wait for some undetermined date in the future, stimulating economic activity. But it’s important for the Fed to keep a thumb on the scale. According to the FOMC in a 2020 statement, the target goal for inflation has been 2% per year.
The Fed must do its best to maintain an equilibrium between these two factors when it sets the benchmark short-term interest rate, which is the rate at which federally insured banks can borrow money each night. The current range for the Fed funds rate is 0 – 0.25%
Although the most immediate impact may be felt in the rates for short-term lending – credit cards, personal loans and auto loans – longer-term payoffs like mortgages do tend to correlate with these short-term rates. Depending on market factors, which we discuss below, the base interest rate for a mortgage might run 2 – 3% higher than short-term rates.
Base Market Rates And Bond Trading
When the practice of lending money so people could buy homes first started, a bank would look at the qualifications of the borrower and, if they made a loan, hold on to it until the loan was paid off, potentially 20 or 30 years down the line.
While some banks still do this today, the advent of the MBS has changed things up a bit. Let’s look at a brief overview of how the process works.
After your loan closes, it’s packaged up with other mortgages that have similar characteristics to your loan. As an example, a single MBS might have 100 conventional loans with credit scores above 680 and down payments of 15 – 20% on primary properties.
The investor – most often an institution, but it could be an individual – can buy this at a rate of return dictated by the market. Those rates of return are what’s important in determining mortgage rates.
The advantage of this system for a mortgage originator is that they can receive cash from a mortgage investor who backs the bond and packages it as an MBS, giving them the capital to make more loans without having to wait for payments to come in over the full course of the term. For a consumer, more loans are available at favorable terms.
The stock and bond markets tend to operate with a push-pull effect. Stocks are considered riskier because they are fed by corporate earnings results and, often, by speculation on what a company will or won’t do well off into the future. They’re somewhat more speculative, but they can offer a higher rate of return in exchange for the increased risk.
Bonds, on the other hand, could be for anything from local municipal projects to large-scale government operations to mortgage bonds – the last of which are paid into each month when homeowners make their payments. Since the borrowing that underlies bonds tends to be for essential goods and services, this is considered a much safer investment in stocks, because people will pay off the necessities.
This is where the push-pull comes in. When stocks are going up and people are feeling good about the state of business and the economy, they pour more money into equities and take it out of bonds. Because MBS are traded on the bond market, mortgage rates tend to rise, as the rate of return on bonds needs to be higher in order to attract investors. On the other hand, if people are uncertain about the future at home or abroad, the money goes back into the safety of the bond market, which can have the effect of lowering mortgage rates.
In addition to setting monetary policy, the Fed has in recent years played a role here as well. Because housing plays such a key role in the economy, the FOMC has chosen to dive into the bond market, buying MBS with the aim of helping support the environment of low mortgage rates. The committee has accelerated purchases of MBS in response to COVID-19. A statistical release by the Federal Reserves shows MBS holdings of the Fed are sitting around $2.04 trillion at the time of this writing.
If all things were equal, the movement of the bond market in one direction or another on a particular day would determine your mortgage rate. However, your personal financial profile is considered as well.
Factors That Affect An Individual’s Personal Rate
An important thing to remember about mortgage rates is that, in addition to market factors, they’re also determined in part by the level of perceived risk. If you’re considered a lower risk, you’ll get a better rate than someone with higher risk factors.
Among the risk-based metrics lenders use to revalue your qualifications are:
- Your credit score and negative items on your credit report
- The size of your down payment
- The type of property you’re buying or refinancing
Another factor that can impact your rate are the closing costs and other financial decisions associated with your loan. Let’s briefly go over a few examples:
Prepaid interest or mortgage discount points are a way to buy down your interest rate. One point is equal to 1% of the loan amount. Determining whether it makes sense to buy points involves doing a little bit of math.
Let’s say you’re buying a $200,000 home and paying for 2 points will save you $50 on your monthly payment. Since the cost of the points would be $4,000 (200,000*0.02), you divide this number by 50 to get the break-even point: 80 months.
In other words, if you plan on staying in the house for more than 6 years and 8 months, it can make sense to buy the points, because you’ll save money over time. Otherwise, you shouldn’t buy the points, or you should buy fewer points.
On the other hand, if you want to keep closing costs down, you can opt to take a credit from your lender to roll the closing costs into the loan in exchange for a slightly higher rate.
Finally, if you make a down payment of less than 20%, you’ll likely have to pay for mortgage insurance or an equivalent. The exception to this is VA loans, which have a one-time upfront funding fee that can be rolled into the loan if desired.
With conventional loans, you have the option of making the mortgage insurance payment on a monthly basis or having the lender pay for the policy upfront and taking a slightly higher interest rate compared to loans without lender-paid mortgage insurance (LPMI).
However, there is also something called single-pay mortgage insurance. With this option, you can pay for part or all of your mortgage insurance policy upfront to get a lower rate while still avoiding a monthly mortgage insurance payment.
Understanding Mortgage Investors
Now that we understand how rates work, let’s take a quick look at some of the other aspects of the mortgage market.
As mentioned above, the mortgage investor plays an important role in providing cash flow in the mortgage market, but who are they and what do they really do?
Who Are The Major Mortgage Investors?
In some cases, the bank that originated your loan is also the investor in that mortgage, but this has become less and less common in recent years. Most loans nowadays are sold to one of five major mortgage investors:
- Fannie Mae
- Freddie Mac
- Federal Housing Administration (FHA)
- S. Department of Agriculture (USDA)
- Department of Veterans Affairs (VA)
Fannie Mae and Freddie Mac provide what are referred to as conventional or agency loans and are government-sponsored enterprises (GSEs). The last three are loan options offered by the federal government and really roll up to one investor, Ginnie Mae.
Each investor has strict standards regarding which loans they’ll buy, and that helps determine what loan type you qualify for.
What Do Mortgage Investors Do?
Mortgage investors buy mortgage loans and then provide insurance. Essentially, they allow bond market investors to buy the loans with the confidence that even if several people in a pool of 100 or 1,000 loans default, the regular investor in the bond market won’t lose their shirt.
In exchange for this insurance, these initial investors act as the middleman between the originators and the bond market at large. They package the loans up into an MBS and mark up the price a bit for a profit. There is also sometimes a difference in the appetites for certain types of loans, which can account for differences in interest rates between FHA and conventional loans of the same term, for example.
What Happens If Your Loan Is Sold?
Selling mortgages is a common occurrence after your closing. It’s likely you’ll receive a notification that your loan has been sold to an investor within a month or two after your closing. However, that doesn’t necessarily mean your relationship with your lender is ending.
Closing will typically take 30 – 50 days. After closing, you enter the servicing phase of your loan transaction until the house is sold, refinanced or otherwise paid off. In addition to collecting your monthly principal and interest payments, the servicer will collect monthly for your property taxes and homeowners insurance, if you have an escrow account, as well as for your mortgage insurance, if applicable. You should also contact your servicer if you were to run into financial trouble and need payment assistance.
The Bottom Line
The mortgage market consists of two parts: a primary and a secondary market. The primary market consists of lenders that originate mortgages for consumers. The secondary market consists of mortgage investors like Fannie Mae, Freddie Mac, the FHA and so on. These institutions buy mortgages to provide liquidity for lenders to make additional loans.
An MBS is a package of existing loans that investors can buy in order to benefit from the principal and interest payments. Many of these are backed by Fannie Mae, Freddie Mac or Ginnie Mae, the agency that’s responsible for backing government loans from entities like the FHA and VA.
At the market level, mortgage interest rates are influenced by both bond trading and the Federal Funds Rate. However, lending is risk-based, and personal factors like your credit score, down payment and the type of home you’re buying have a major effect. Once you’ve closed your loan, mortgage investors buy the loan and provide fresh liquidity for the market.
Now that you've gained a clearer understanding of the inner workings of the primary and secondary mortgage markets, you might feel ready to take the next steps toward applying for or refinancing your mortgage. Talk with one of our experts and get started today!