How markets normally determine mortgage rates

Few lenders want to put their own money into lending to you for 30 years. As long as they own your mortgage, they can’t lend that money to anyone else.

So what most lenders do is place your mortgage within a bundle of “mortgage-backed-securities” (MBS). These MBS are then sold to investors, who make money off the interest mortgage borrowers pay.

By selling mortgages in this fashion, lenders generate cash to make new mortgage loans.

Buying and selling of MBSs happens in a “secondary market,” not all that different from the stock or bond markets. In fact, MBS are a sort of bond.

When you’re buying or refinancing a home, the going price of MBS bundles on the secondary market largely determines your mortgage rate.

And, if you’re currently buying or refinancing a home, it’s largely the going price of these bundles on that secondary market that determines your next mortgage rate.

However, as you’ll discover soon, MBS prices are the main rather than the only determinant.

When lots of investors want to buy MBS, the price goes up and their yield and your mortgage rate go down. But when demand is low the opposite happens and your mortgage rate goes up.

That may seem counterintuitive. But it’s a mathematical certainty. And we’ll explain why later.

Why the Fed is having a bigger impact on mortgage rates

Challenges to the Fed’s low interest rate policy

The Fed and mortgage rates: how the system usually works

We started by talking about widespread misunderstandings about the usual relationship between the Fed and mortgage rates.

And that confusion’s understandable. Because the Fed does have control over other interest rates.

When the Fed’s policy body (the Federal Open Market Committee, or FOMC) changes the federal funds rate, that has a direct effect on many variable-rate consumer loans: credit cards, personal loans, auto loans, and so on.

But, of course, the vast majority of mortgages (over 90%) have fixed rates. So they’re not affected.

And neither are new mortgages, at least directly. As we’ve established, it’s the price of MBS on the secondary market that mostly determines what your new mortgage’s rate will be.

Naturally, you can argue that Fed rate decisions impact investor sentiment, indirectly, anyway. But it’s often imperceptible.

What causes mortgage rates to rise and fall

We promised earlier to explain why yields fall as bond prices rise. Most importantly, when those bonds are MBS, it’s mortgage rates and investor yields that go down when prices rise — or go up when they fall.

Now, if you have a low tolerance for numbers, you can just take our word for that. But, if you’re interested in the math, read on.

In normal times (less so when the Fed is buying MBS), mortgage interest rates depend a great deal on the expectations of investors.

Good economic news tends to be bad for interest rates, because an active economy raises concerns about inflation. Inflation causes fixed-income investments like bonds to lose value, and that causes their yields (another way of saying interest rates) to increase.

For example, suppose that two years ago, you bought a $1,000 bond paying 5% interest ($50) each year.

• Your interest rate: $50 annual interest / $1,000 = 5.0%

This is called its “coupon rate” or “par rate” because you paid $1,000 for a $1,000 bond, and because its interest rate equals the rate stated on the bond — in this case, 5%.

When rates fall

That’s a pretty good rate today, so lots of investors want to buy it from you.

You can sell your $1,000 bond for $1,200. The buyer gets the same $50 a year in interest that you were getting. It’s still 5% of the $1,000 coupon.

However, because he paid more for the bond, his return is lower.

• Your buyer’s interest rate: $50 annual interest / $1,200 = 4.2%

The buyer gets an interest rate, or yield, of only 4.2%. And that’s why, when demand for bonds increases and bond prices go up, interest rates go down.

When rates rise

However, when the economy heats up, and the potential for inflation makes bonds less appealing, fewer people want to buy bonds. So their prices decrease, and then interest rates go up.

Imagine that you have your $1,000 bond, but you can’t sell it for $1,000 because unemployment has dropped and stock prices are soaring. You end up getting $700. The buyer gets the same $50 a year in interest, but the yield looks like this:

• $50 annual interest / $700 = 7.1%

The buyer’s interest rate is now slightly more than 7%. Interest rates and yields are not mysterious. You calculate them with simple math.

The Fed’s new control over mortgage rates is temporary

The Fed’s mortgage interventions began in response to the economic consequences of the 2020 pandemic. And many economists believe they’re an appropriate response to that crisis.

But this relationship between the Fed and mortgage rates is unlikely to survive or be part of the new normal that emerges once COVID-19 recedes.

It’s a temporary measure. And the sooner it’s over the better for the wider economy.

That means many mortgage customers will want to move forward sooner rather than later.