Where Do Mortgage Rates Come From Anyway

Many mortgage applicants, especially first-time home buyers, wonder, “How does a lender determine my mortgage rate?” It’s important for consumers to understand the basics of how mortgage rates are “made” because an informed homebuyer is a more confident one.

In the most basic sense, the price of bonds, stocks, cars, land, and homes – nearly everything that can be bought and sold – is determined by supply and demand.

If there is only one house on the lake, and hundreds of people would like to own it, the price will be driven higher. Conversely, a car dealer’s lot could be full of used orange 1975 Ford Pintos with questionable safety records that no one wants to buy, in which case the prices would have to drop to attract any buyers.

Mortgage rates act in the same way. There are personal factors that contribute to your individual loan’s price, but also forces of supply and demand.

Personal factors affect your loan’s “price,” otherwise known as the mortgage rate and associated fees, too. These include (but are not limited to) one’s credit record, whether you will occupy the property, your overall financial situation, and the size of your loan compared to the value of the property you’re purchasing. The safer your loan profile, the greater potential for a lower mortgage rate.

But then there is supply and demand, which is a little tougher to understand when it comes to mortgage rates. Here’s how that part works.

How supply and demand affect mortgage rates

If I told you that I was going to pay you $100 a month for the next 30 years, that income has value to you. If someone else told you that they were going to pay you $120 a month for the next 30 years, that would be more valuable to you.

That is exactly the way a bond’s interest is paid to investors, and also other payments for other investment types such as quarterly stock dividends (more on why your mortgage is a bond later).

In short, the investor owns an asset, and that asset pays that investor a certain amount at a certain time. After all, investors typically don’t want their cash sitting around, being eaten by inflation. They are spurred to invest that money and get a return.

Lucky for them, there is a supply of stocks and bonds out there for investors to buy. Many of these securities have an active, liquid market. In other words, it is relatively easy for an individual, or a large institutional investor, to purchase them. Think things like a stock in IBM or a savings bond issued by the U.S. Government. A security backed by mortgages can also be traded in a liquid market.

Your home loan is a type of bond. You make monthly payments, and those have value. The majority of loans are “securitized” and sold to investors. The term “securitize” refers to the process of pooling or packaging financial assets like home loans together. This process creates new securities that can be marketed and sold to investors.

Nearly anything can be pooled: mortgages, credit card debt, car loans, student loans, and other forms of contractual debt. Even a musician’s future cash flows from an upcoming series of concerts can be securitized, and have been!

Home loans are usually securitized to clear them off the balance sheet of the originating lender. This frees up credit so that the bank or lender can lend again to new borrowers.

How does the lender know how much the new security is worth and how much to sell it for? That depends on how much cash it throws off to the investor. A pool of higher-rate mortgages sells for more than one with lower-rate loans.

The majority of home loans are originated based on rules set forth by FNMA (Federal National Mortgage Association, or Fannie Mae), FHLMC (Federal Home Loan Mortgage Corporation, or Freddie Mac), or GNMA (Government National Mortgage Association, or Ginnie Mae).

This is convenient, because these three institutions are responsible for roughly 90 percent of the outstanding $11 trillion in mortgage-backed securities. (For comparison purposes, there are $22 trillion in U.S. Treasury securities outstanding.) And people’s home loans across the nation act as collateral for these bonds.

What impact do investors have mortgage rates?

Most consumers don’t know that their mortgage is packaged up by a large agency and sold to investors. When you buy a home, your mortgage payments go toward giving those investors a return on their money. But that’s not a bad thing. It provides more access to credit, which provides fuel to the housing market thereby helping your home value grow.

The typical mortgage-backed security (MBS) issued by Fannie Mae, Freddie Mac, or backed by Ginnie Mae consists of a collection of mortgages, often from across the nation. And these MBS are actively traded on the secondary market, enabling investors to earn a return. But just as importantly, lenders watch the prices at which these securities trade in order to set the rates and prices for borrowers.

So the bottom line is that the investors in the market determine a big part of your mortgage rate. Not the Federal Reserve (a.k.a. “the Fed), your bank, or an individual lender. (The exception is when the Federal Reserve is also an investor, which happens to be the case at the moment. But still, the Fed does not set mortgage rates.)

Related reading: Fed Accelerates Taper, Clears Path for Interest Rate Hikes in 2022

The securitization process is nearly invisible to the typical borrower. When an investor buys a mortgage-backed security, she, he, or it is essentially lending money to home buyers. In return, the investor owns the rights to the value of the mortgage, and receives their money back with interest via the borrower’s monthly principal and interest payments.

Selling mortgages helps lenders keep lending to future customers: Mortgage companies like Fairway Independent Mortgage Corporation, which owns this website, acts as the go-between for MBS investors and home buyers.

Who buys mortgages from lenders?

Typical buyers of MBS include individual investors (yes, you can buy mortgage-backed securities, too), corporations, and institutional investors. Monthly principal and interest payments are passed through to the investors.

And these are viewed as very safe investments. That’s why there is high demand for MBS during times of economic uncertainty. It’s also why, in part, mortgage rates dropped to all-time lows – even into the 2s – as the COVID-19 pandemic emerged.

Knowing where investors are buying and selling these securities, just as an individual might know the price of Ford Motor Company’s stock, is critical in determining the rate and price that a borrower sees advertised by a lender or on their loan estimate. In other words, the price at which certain MBS are being bought and sold in the capital markets establishes the base price for mortgages!

And now, if you wonder, “Where do mortgage rates come from,” you just have to think about how much the end investor would like to receive for investing in that asset, your mortgage.

Fairway is not affiliated with any government agencies. These materials are not from VA, HUD or FHA, and were not approved by VA, HUD or FHA, or any other government agency. Fairway is not a Licensed Financial Advisor. The information in this advertisement does not constitute financial planning advice. Please consult a financial planner regarding specific questions or situations.