How Do Mortgage Interest Rates Work? - Fixed Interest Rates versus Adjustable Rate Mortgages & Forecasting Interest Rates

(April 21st, 2008)

There are 2 main types of mortgages; fixed rate and adjustable rate mortgages. If you have a solid understanding of how mortgage interest rates work and what economic/social factors affect them, you will better be able to structure your mortgage loan; for example decide between a fixed rate mortgage or an adjustable rate mortgage. It is also beneficial to know the future direction of interest rates in the economy that will impact mortgage interest rates.

The Mortgage Industry

The mortgage industry has 3 main parties doing business; the mortgage originators, the aggregators and the investors.

1) The Mortgage Originators

The mortgage originator is the first company with which a borrower does business. Examples of mortgage originators include banks, mortgage brokers and bankers. The difference between banks & mortgage brokers is that banks use their own money to close the mortgages, while mortgage brokers act as a source of connection between the borrowers & the banks. The difference between banks & mortgage bankers is that mortgage bankers use a 'warehouse line of credit' to fund loans and then sell these newly originated loans to investors in the secondary market.

Many banks prefer to aggregate or accumulate mortgages for a period of time before selling them on the secondary market as a whole. Other banks prefer to sell each mortgage individually as soon as they are originated. This is done so as to eliminate risk; because as soon as a bank locks in a specific interest rate for a borrower, it is taking on a great risk. While interest rates on the market may have moved higher, the bank is locked in at a lower interest rate thus not allowing it to make more money. In order to avoid this, some banks hedge the interest rate on their mortgages sold so as to avoid interest rate fluctuations. Mortgage originators make money via the closing costs that are charged to originate a loan + the interest rate differentials between what the borrower locks in and the premium that secondary market investors will pay.

2) The Aggregators

The Aggregator is the second participant in the secondary markets. Examples of an aggregator include large mortgage originators affiliated with the Federal government and Wall Street. They are Fannie Mae and Freddie Mac. Aggregators purchase newly originated mortgages from smaller originators (such as mortgage bankers & the banks) and together with their own originations securitize their investments into private mortgage-backed securities.

3) The Investors

Investors are the final buyers of mortgage-backed-securities. They are insurance companies, pension funds, hedge funds such as Bear Stearns, foreign governments and some mutual funds. Collaterized mortgage & debt obligations sold to investors offer a higher yield potential based on the quality of credit and risks of interest rates.

Who Determines Mortgage Interest Rates?

To a large extent, the mortgage-backed-securities (MBS) investors' do. If you read the article on >> Mortgage Loans: A Look Behind the Scenes <<, you know that a mortgage loan originated from a bank ends up as a mortgage-backed-security sold to the end investor. Free market forces determine the price investors will pay for a mortgage-backed-security and this has a direct bearing on mortgage interest rates.

Fixed Interest Rate Mortgages

The average lifespan of a 30 year fixed-interest rate mortgage is only 7 years. This is because homeowners tend to refinance their mortgages with lower interest rates to save on their monthly payments. Mortgage backed securities (MBS) are highly correlated with prices of US Treasury bonds. This simply means that the price of a mortgage-backed-security backed by a 30 year mortgage will move in correlation with the price of a 5 year US Treasury bond note. Since 5 years is less than 7 years duration (which from above is the average lifespan of a 30 year fixed interest rate mortgage due to refinancing), the 10 year US Treasury bond is used as a benchmark. Thus, fixed-interest rate mortgages move in correlation with the 10 year US Treasury bond interest rates.

Now you might ask, what impacts the rate on US Treasury bonds? Economic expectations determine the prices & yields of US Treasury bonds. When there is inflation, investors know that it will erode the value of future bond principal & interest payments. Therefore, they take money out of the bonds and invest it elsewhere, in commodities such as Gold, Silver or Oil. Thus when inflation is high, bond prices fall, while the yields increase. There is an inverse relationship between a bond's price and its yield.

The Federal Reserve plays a big role in igniting or killing inflation. Through administration of short term interest rates, bondholders know the direction of long term interest rates and as such, the direction of yields offered on the 10 year US treasury bond. You can predict future mortgage interest rates by looking at the Federal Reserve's monetary policy and inflation expectations. If the Fed is committed to killing inflation, the yields on the US treasury bonds will increase as flow of money going into bonds will rapidly increase and the price of bonds will increase. Thus in this case, long term mortgage interest rates will go up.

Adjustable Rate Mortgages

Interest rates on adjustable rate mortgages change once every month, 6 months or 1 year, depending on the term of the mortgage loan. The interest rate consists of 2 components; the index value + margin. Together, these two components are known as the fully indexed interest rate. The index value is variable while the margin is fixed for the life of the mortgage. For example, if the current index value is 5.85% while the Margin is 2.5%, the fully indexed interest rate will be 8.35% The 2.5% margin will never change over the life of the mortgage. The index value is tied to a particular financial index. An example is the Federal Funds rate. The Federal Funds rate is the rate at which banks or depository institutions lend money in overnight loans to other banks & depository institutions.

Forecast Interest Rates

When trying to predict interest rate changes on adjustable rate mortgages, look at the shape of the yield curve. The yield curve shows the yields on US Treasury bonds with maturities from 3 months to 30 years. When the yield curve is flat or downward sloping, it signals the Fed is going to keep short term interest rates steady or lower by a few basis points. When the yield curve is upward sloping, the market predicts the Fed will move short term interest rates higher.

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