How are mortgage rates determined and why do they change so often? This is a question we hear almost every day at Gershman. Below you will find a brief overview of how mortgage rates are set and what influences them up or down.

Mortgage rates are determined by a variety of economic and social factors that occur every day. These factors influence rates both positively and negatively. The number of all factors affecting mortgage rates is rather large so we will focus on the main influencers.

Short Version
There are too many individual economic and social factors that influence mortgage rates each day, so we will focus just a few main influencers and their impact on mortgage rates.

Investors play a large role in setting mortgage rates. The mortgage-backed securities (MBS) market is very similar to the stock market. The more demand investors have for MBSs (explained in the long version), the lower the rates. Less demand from investors means higher mortgage rates.

These investors are driven to invest in MBSs for a variety of reasons, some of which are a result of geopolitical events occurring around the world. Tension in the Middle East, debt worries in Europe, natural disasters such as the earthquake in Japan, and other world events all drive investors to seek more stable investments, resulting in them buying more MBSs and Treasury bonds. This increase in demand also lowers the mortgage rates.

Inflation is a big influencer of mortgage rates. As the economy grows and demands for resources increases, inflation increases. Inflation erodes the value of the dollar, causing the lender to demand additional dollars back at a later date to compensate for lost purchasing power. Since mortgage rates are fixed for the life of the loan, inflation can reduce an investor’s return. So as inflation increases, so do mortgage rates. The Federal Reserve also influences mortgage rates as a result of its efforts to control inflation.

The bottom line is that there is a never-ending list of influencers that positively or negatively impact mortgage rates. Understanding the key elements will enable you to make better decisions when determining when to lock your rates and to avoid feeling like you are gambling with your mortgage.

Long Version
Before we jump into the influencing factors, we will quickly explain the history behind mortgage rates. Years ago, mortgages were originated similar to today, but were lumped into a portfolio together and sold to investors. This caused concern for investors because if there was an economic downturn in that specific region (oil industry bust in Texas or auto industry slowdown in Detroit), there was greater risk of default at the same time, resulting in the investor losing everything and amplifying the negative impact on the economy. To counterbalance this risk, mortgages from around the country were diversified and pooled together, a process called securitization, to alleviate some of the risk that these portfolios posed to investors.

This is where the name Mortgage-Backed Securities (MBS) came from. If a downturn in a region occurred today, only a small portion of mortgages in the portfolio were affected, preventing from the regional economy to suffer. The emergence of MBS portfolios resulted in greater demand, driving up prices and lowering mortgage rates.

The process was not perfect right away. Investors objected to owning MBS portfolios because there was concern that lenders did not have any incentive to ensure the quality of loans they originated due to the fact that they were selling them off immediately as MBS portfolios. To quell investor concerns, Freddie Mac, Fannie Mae, and Ginnie Mae were created by the federal government to address these concerns. These agencies created credit standards that lenders had to abide by in order to sell the mortgages to investors. The agencies also guaranteed the loans, removing much of the risk for investors.

There still remain a few elements of risk for investors. Mortgages can be repaid early, reducing the amount of returns expected and inflation can rise over the life of the loan, devaluing the inflation adjusted return since most interest rates are fixed over the life of the loan.

MBS portfolios are traded similar to stocks where prices are set based on investor demand, which means the prices of MBS portfolios drive mortgage rates. This contributes to the reason why mortgage rates are constantly changing. Lenders issue rate sheets multiple times per day and will honor these rates until a change in MBS prices reaches a certain threshold. Once this happens, lenders will issue a new rate sheet updating rates.

While supply and demand contribute to changes in mortgage rates, it is wise to look at what influences supply and demand. There are many reasons why investors may increase their investments in MBS portfolios and there are many why they will withhold from investing. We will look at a few key influencers and examine how they impact your mortgage rate.

The first factor is economic growth (or decline). The faster the economy is growing, the more demand for capital, which translates to a higher cost to borrow money. The general rule of thumb is that positive economic news (less unemployment, GDP growth, more purchasing, higher consumer confidence, etc.) results in higher mortgage rates. Negative economic news usually results in lower rates. Investor confidence is a key element when determining rates because one can usually predict where they will move their investments. A more volatile environment means investors want to invest in something with little risk and a more stable environment means investors want to increase their returns and capitalize on growth, moving their investments back into the stock market and other investment areas that have slightly more risk.

This can also explain why rates decrease during times of global conflict or geopolitical events that threaten stability. These events cause investors to seek less risky investments driving them to Treasury bonds and MBS portfolios.

The second factor is inflation. As the economy grows and demands for resources increases, inflation increases. Inflation erodes the value of the dollar, causing the lender to demand additional dollars back at a later date to compensate for lost purchasing power. Since mortgage rates are fixed for the life of the loan, inflation can reduce an investor’s return. The rate of inflation is usually factored into the investor’s decision making, but anything that can change the expected rate will cause a rise or decline of mortgage rates. MBS prices are highly sensitive to this information and the reactions of investors are reflected in the prices changes.

The Federal Reserve also impacts mortgage rates through its efforts to control inflation. The bond market’s perception of how well the Federal Reserve is controlling inflation through the administration of short-term interest rates determines longer-term interest rates. The Federal Reserve sets current short-term interest rates, which the market then interprets to determine long-term interest rates.

To forecast interest rate changes, one can look at the shape of the 10 year Treasury bond curve. A flat or downward sloping curve means the market expects the Federal Reserve to keep short-term interest rates steady or lower them. An upward slope means the market expects the Federal Reserve to move short-term interest rates higher. The steepness of the curve in either direction is a good indicator of how much the market expects the Federal Reserve to raise or lower rates.


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