How are mortgage rates determined?

Contrary to popular belief, mortgage interest rates are not determined by a single person or a group of people sitting in an ivory tower somewhere in Anytown, USA, attempting to take advantage of us. Rather, they are determined by market conditions that change daily. These market conditions would entail both micro and macro events impacting the current and anticipated state of the economy. (Beginning to sound a little Alan Greenspan-ish - sorry!) A few examples of microeconomic events would be the September 11th terrorist attack, the Florida hurricanes of ’04 or the sudden spike in the price of oil. On the other hand, a few examples of macroeconomic events would be inflation, employment, or government deficits. These macroeconomic events are the ones most closely watched by the FED in their efforts to maintain a well-balanced economy. (You can learn more about this concept by going to “What is the role of the FED?” in this section of Frequently Asked Questions.)

While the FED is diligently attempting to fine tune the economy by affecting interest rates on Treasury Bills, Notes and Bonds, these actions are simultaneously impacting mortgage rates. This relationship is best illustrated using the example of an investor like you or me wanting to invest, say, $1,000. While there are many investment choices available to us, let’s assume that we have narrowed our choices to either a U.S. government bond or a mortgage-backed security. (The current yield on mortgage back securities determine current mortgage interest rates.)

Let’s further assume that the current yield or rate of return on the bond is 5.000% and the current yield or rate of return on the mortgage backed security is 7.500%. In which should we invest? If we invested our $1,000 in the bond, we would receive $50 per year; if we invested in the mortgage-backed security, we would receive $75 per year. Duh…..give me the $75 per year! Oh, but not so fast - While there is little or no risk associated with the bond, there is a certain degree of risk associated with the mortgage investment. So we need to evaluate the risk in the mortgage investment and determine if the extra $25 per year is worth the added risk. After evaluating the risk, we decide that the extra return is worth the extra risk so we purchase the mortgage-backed security, and interest rates for mortgages remain constant at 7.500%.

During the following month or so, the FED is busy tightening interest rates which cause the yield on the bond to increase from 5.000% to 6.000%. Will this affect mortgage interest rates? Yes it will, because of investors like us. We are still holding our investment in a mortgage backed security yielding 7.500%, remembering that our decision was based on the extra $25 we were receiving for the additional risk we were taking. However, since the bond is now yielding 6.000% or $60 per year the dollar premium for the additional risk is reduced from $25 to $15. Realizing this, we decide to sell our mortgage-backed security and purchase the bond with the higher yield……presumably, other investors holding the same mortgage backed security would do likewise for the same reason. As more and more investors like you and I continued to sell our mortgage-backed securities, the price of these securities would eventually fall to the point where they would once again pay a dollar premium of $25 for the additional risk. Thus if we were receiving $60 on our new bond investment, we would not consider switching to another mortgage-backed security investment until such time that the annual return is $85. At that point in time, we would sell our bond in favor of purchasing the mortgage-backed security with a yield of 8.500%, hence, establishing the new mortgage interest rate of 8.500%.

Below you will find both a chart and a graph that help show the relationship of bond rates and risk premium to mortgage rates. These visuals use the example above related to a mortgage rate increase between May - June (7.50% to 8.50%) , as well as an illustration of a mortgage rate decrease between September - October (8.50% to 8.00%).

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