Mortgage interest rates: how are they determined?
Mortgage interest rates are the single most important factor determining the borrowing power of a prospective homebuyer. When rates are very low, a borrower can pay off a large amount of debt with a relatively small payment, and when interest rates are very high, a borrower can pay off a small amount of debt with a relatively large payment.
Mortgage interest rates are determined by market forces where investors in mortgages and mortgage-backed securities bid on these assets. The rate of return required by these investors determines the interest rate that the originating lender must charge to sell the loan in the secondary market. Some lenders still have mortgages in their own investment portfolio, but these mortgages and mortgage rates are subject to the same supply and demand pressures generated by the secondary mortgage market.
Mortgage interest rates are determined by investors’ demands for a risk-adjusted return on their investment. Investors’ demand for return is determined by three main factors: the risk-free rate of return, the inflation premium, and the risk premium.
The risk-free rate of return is the return an investor could earn on an investment such as a short-term Treasury bill. Treasury bills range in duration from a few days to 26 weeks. Due to their short duration, Treasury Bills contain little or no margin for inflation. A close approximation of this rate is the Federal Funds Rate controlled by the Federal Reserve. It’s one of the reasons investors keep such a close eye on the activities of the Federal Reserve.
The closest risk-free approximation to mortgage lending is the 10-year Treasury Note. Treasury Bonds accrue a fixed interest rate every six months until maturity, issued at terms of 2, 5 and 10 years. The 10-year Treasury note is a close approximation to home loans because most fixed-rate mortgages are paid off before the 30-year maturity, with 7 years being a typical repayment term.
The yield difference between a 10-year Treasury note and a 30-day Treasury bill is a measure of investors’ expectation of inflation, and the difference between the yield on a 10-year Treasury note and the rate of The prevailing market mortgage interest rate is a measure of the risk premium.
Inflation reduces the purchasing power of money over time, and if investors have to wait a long period of time to be repaid, as is the case with a home mortgage, they will receive dollars that are worth less than what they provided when the loan was made. originated. Investors demand compensation to offset the corrosive effect of inflation. This is premium inflation.
The risk premium is the additional interest that investors demand to compensate them for the possibility that the investment does not work out as planned. Investors know exactly how much they will get if they invest in Treasuries, but they don’t know exactly what they will get back if they invest in residential home mortgages or the investment vehicles created from them. This return uncertainty leads them to ask for a higher rate than Treasury Notes. This additional compensation is the risk premium.
Therefore, mortgage interest rates are a combination of the risk-free rate of return, the risk premium, and the inflation premium.