The calculations and actions that go into setting prevailing mortgage rates are quite complicated, but it’s possible to break these down into a few major influences. Actually, local banks and lenders don’t have much influence on mortgage rates. Rather, these rates are largely determined by more general and broad factors.
Watch The Fed
The Federal Reserve exerts a pretty powerful influence over mortgage rates. When the Fed adjusts its funds rate, then banks also modify their interest rates. Some lenders set rates based on 10-year T bill projections, while others evaluate indexes and other bonds.
So, you’ll notice that when 10 year bonds fluctuate, mortgages will follow suit. This can be particularly damaging for people who have adjustable mortgages, if rates increase.
The Secondary Market
When a bank or financial institution gives you a loan, it’s not often that they hold onto the loan. In fact, it’ll probably travel to what’s called the secondary mortgage market. Here’s how this works:
The bank will sell your loan to a third party or outside investor. Often, the bank will sell it to a mutual fund. The purchaser of the loan is usually called the aggregate.
Then, the aggregate puts your loan in a basket with many other loans to form what’s called a mortgage-backed security, or MBS.
The aggregate will probably divide up the security into a variety of different stocks, called tranches, to sell back to investors.
How Do Investors Earn Funds On Tranches, and How Does It Affect Me?
Investors purchase these tranches so that they can get a return on what they’ve invested, which is theoretically supposed to come from mortgage payments. So, you can see already that it’s the best interest of the lender and the aggregator to balance the financial interests of investors as well as buyers.
If a mortgage rate is unilaterally low, then it will attract a lot of buyers. But, if the rate is higher, then more investors are likely to jump on board and invest. Both the buyer and the investor are competing to acquire what’s in their best interest.
So, the secondary mortgage market plays a huge role in determining mortgage rates. But there’s more to it. Often, the mortgage rate will be determined by the price at which the aggregator is willing to purchase any loan. Remember, that price is dependent upon the success of selling mortgage-backed tranches. Therefore, since investors determine the rate of tranches, you can see that individual investors can have a huge effect on mortgage rates.
A Variety of Factors
Factors such as the Federal Reserve, the strength of the U.S. economy, the rate of inflation, and many other things affect investors’ willingness to take risks. Huge inflation will deter investors, while moderate inflation is actually a sign of a good economy.
Remember, since investors can freely choose where to invest, competition with other investments will also determine mortgage rates. If investors can find a good return on mortgage-backed securities, then they’ll be more likely to purchase them.
Most investors are hip to adjustments made by the Federal Reserve, which is basically why this institution has such a profound influence on mortgage rates.
As you can see, investors are really the main factor that affects mortgage interest rates and home loans.
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