Mortgage loans come in two primary forms—fixed rate andadjustable rate—with some hybrid combinations and multiple derivatives of each. A basic understanding ofinterest ratesand the economic influences that determine the future course of interest rates can help you make financially sound mortgage decisions. Such decisions include choosing between a fixed-rate mortgage and an adjustable-rate mortgage (ARM) or deciding whether to refinance out of an ARM.
Key Takeaways
- Understanding interest ratesis key to making financially sound mortgage decisions.
- The interest rate is the amount a borrower is charged for the privilege of being loaned money.
- Interest rates on mortgages are determined by a number of factors, including the state of the general economy and your personal circ*mstances.
- Mortgage lenders often peg their interest rates to the 10-yearTreasury bondyield.
- Looking at the shape of the yield curve can help when trying to forecast interest rate changes on ARMs.
How Are Interest Rates Determined?
The interest rate is the amount charged on top of the principal by a lender to a borrower for the use of assets. The interest rate charged by banks is determined by a number of factors, such as the state of the economy. A country's central bank sets the interest rate, which each bank uses to determine the range of annual percentage rates (APRs) they offer.
Central banks tend to raise interest rates when inflation is high because higher interest rates increase the cost of debt, which discourages borrowing and slows consumer demand.
The Mortgage Production Line
The mortgage industry has three primary parts or businesses: themortgage originator, theaggregator, and the investor.
The Mortgage Originator
The mortgage originator is the lender. Lenders come in several forms, like credit unions and banks. Mortgage originators introduce, market, and sell loans to consumers and compete with each other based on the interest rates, fees, and service levels that they offer. The interest rates and fees they chargedetermine theirprofit margins.
Most mortgage originators do not “portfolio” loans (meaning that they do not retain the loan asset). Instead, they often sell the mortgage into thesecondary mortgage market. The interest rates that they charge consumers are determined by their profit margins and the price at which they can sell the mortgage into the secondary mortgage market.
The Aggregator
The aggregator buys newly originated mortgages from other institutions. They are part of the secondary mortgage market and most of them are also mortgage originators. Aggregators pool many similar mortgages together to formmortgage-backed securities (MBS)—a process known assecuritization.
An MBS is a bond backed by an underlying pool of mortgages. MBSs are sold to investors. The price at which they can be sold to investors determines the price that aggregators will pay for newly originated mortgages from other lenders and the interest rates that they offer to consumers for their own mortgage originations.
The Investor
There are many investors in MBSs, including pension funds, mutual funds, banks,hedge funds, foreign governments, insurance companies, andgovernment-sponsored enterprises, Freddie MacandFannie Mae.
As investors try to maximize returns, they frequently run relative valueanalysesbetween MBSs and other fixed-income investments such as corporate bonds. As with all financial securities, investor demand for MBSs determines the price they will pay for these securities.
Investors' Impact on Mortgage Rates
To a large degree, MBSs investors determine mortgage rates offered to consumers. As explained above, the mortgage production line ends in the form of an MBS purchased by an investor.
Thefree marketdetermines the market clearing prices investors will pay for MBSs. These prices wind their way back through the mortgage industry to determine the interest rates you'll be offered when you buy your house.
Fixed Interest Rate Mortgages
The interest rate on a fixed-rate mortgage is fixed for the life of the mortgage; however, on average, 30-year fixed-rate mortgages have a shorter lifespan, due to customers moving or refinancing their mortgages.
The rule of thumb used to be that homeowners stayed in their homes an average of seven years; however, that figure has been rising. The median length of homeownership in 1985 was five years, in 2005 it was six years, in 2010 it inched up to eight years, in 2015 it was 11 years, and in 2021 it was 13 years.
MBS prices are highly correlated with the prices ofU.S. Treasury bonds. Usually, the price of an MBS backed by 30-year mortgages will move with the price of the U.S. Treasury five-yearnoteor the U.S. Treasury 10-year bond based on a financial principal known asduration.
In practice, a 30-year mortgage’s duration is closer to the five-year note, but the market tends to use the 10-year bond as a benchmark. This also means that the interest rate on 30-year fixed-rate mortgages offered to consumers should move up or down with the yield of the U.S. Treasury 10-year bond.
A bond’s yield is a function of its coupon rate and price. Economic expectations determine the price and yield of U.S. Treasury bonds. A bond’s worst enemy isinflation, which erodes the value of future bond payments—both coupon payments and the repayment of principal. Therefore, when inflation is high or expected to rise, bond prices fall, which means their yields rise—there is an inverse relationship between a bond’s price and its yield.
The Fed’s Role
TheFederal Reserve(Fed) plays a large role in inflation expectations. This is because the bond market’s perception of how well the Fed is controlling inflation through the administration of short-term interest rates determines longer-term interest rates, such as the yield of the U.S. Treasury 10-year bond. In other words, the Fed sets current short-term interest rates, which the market interprets to determine long-term interest rates, such as the yield on the U.S. Treasury 10-year bond.
Remember, the interest rates on 30-year mortgages are highly correlated with the yield of the U.S. Treasury 10-year bond. If you’re trying to forecast what 30-year fixed-rate mortgage interest rates will do in the future, watch and understand the yield on the U.S. Treasury 10-year bond (or the five-year note) and follow what the market is saying about Fedmonetary policy.
Adjustable-Rate Mortgages (ARMs)
The interest rate on an adjustable-rate mortgage (ARM) might change monthly, every six months,annually, orless often, depending on the terms of the mortgage. The interest rate consists of anindexvalue plus amargin. This is known as thefully indexed interest rate. It is usually rounded to one-eighth of a percentage point.
The index value is variable, while the margin is fixed for the life of the mortgage. For example, if the current index value is 6.83% and the margin is 3%, rounding to the nearest eighth of a percentage point would make the fully indexed interest rate 9.83%. If the index dropped to 6.1%, the fully indexed interest rate would be 9.1%.
With an ARM, homebuyers need to be aware that the monthly cost of their mortgage payments can increase if interest rates increase, and that they should ensure that they can still afford the payments if this happens.
The interest rate on an ARM is tied to an index. There are several different mortgage indexes used for different ARMs, each of which is constructed using the interest rates on either a type of actively traded financial security, a type of bank loan, or a type of bank deposit. All of the different mortgage indexes are broadly correlated with each other. In other words, they move in the same direction, up or down, as economic conditions change.
Most mortgage indexes are considered short-term indexes. “Short-term” or “term” refers to the term of the securities, loans, or deposits used to construct the index. Typically, any security, loan, or deposit that has a term of one year or less is considered short-term. Most short-term interest rates, including those used to construct mortgage indexes, are closely correlated with an interest rate known as thefederal funds rate.
Forecasting Changes
If you’re trying to forecast interest rate changes on ARMs, look at the shape of theyield curve. The yield curve represents the yields on U.S. Treasury bonds with maturities from three months to 30 years.
When the shape of the curve is flat or downward sloping, it means that the market expects the Fed to keep short-term interest rates steady or move them lower. Conversely, when the shape of the curve is upward sloping, the market expects the Fed to move short-term interest rates higher.
The steepness of the curve in either direction is an indication of how much the market expects the Fed to raise or lower short-term interest rates. The price of Fed funds futures is also an indication of market expectations for future short-term interest rates.
How Rates Impact the Housing Market
In general, when interest rates are higher or increasing, the housing market slows down. When interest rates are going up, the cost of owning a home becomes more expensive due to the higher interest rate, which reduces demand. This reduction in demand then results in a drop in home prices.
When the Fed increases rates to slow down the economy, particularly in times of inflation, the above goal is what it's looking for; a reduction in consumer spending that results in a drop in prices.
Conversely, when interest rates drop, the cost of buying a house becomes cheaper, which increases the demand for housing. Lower interest rates go hand in hand with a bustling housing market. This increase in demand then slowly increases home prices.
Why Are Interest Rates Important to the Housing Market?
Interest rates are important to the housing market for several reasons. They determine how much consumers will have to pay to borrow money to buy a property, and they influence the value of real estate. Low-interest rates tend to increase demand for property, driving up prices, while high interest rates generally do the opposite.
Which Factors Influence How Interest Rates on Mortgages Are Set?
There are many factors that impact how much mortgages cost. Lenders will first consider the general cost of borrowing in the economy, which is based on the state of the economy and government monetary policy. Personal factors, such as credit history, income, and the type and size of the loan you are after, will then come into play to determine how much you'll be charged to get a loan to buy a house.
Am I Better Off With a Fixed-Rate or Adjustable-Rate Mortgage (ARM)?
Generally speaking, an ARM makes more sense when interest rates are high and expected to fall. Conversely, if predictable payments are important to you and interest rates are relatively stable or climbing, a fixed-rate mortgage might be your best option.
Popular methods to potentially gauge the future direction of interest rates include studying the yield curve, keeping tabs on the 10-year Treasury bond yield, and paying close attention to Fed monetary policy.
The Bottom Line
An understanding of what influences current and future fixed and adjustable mortgage rates can help you make financially sound mortgage decisions. For example, itcan inform your decision about choosing an ARM over a fixed-rate mortgage andhelp you decide when it makes sense to refinance out of an ARM.
Don’t believe everything you hear on TV. It’s not always “a good time to refinance out of your adjustable-rate mortgage before the interest rate rises further.” Interest rates might rise further moving forward—or they might drop. Find out what the yield curve is doing.
