Mortgage Rates 101, Part 1: What is a Mortgage?

When people want to buy something now, but don’t have (or don’t wish to spend) the cash to buy it outright, they can instead use a loan (aka financing, borrowing, debt). This typically involves an agreement between the consumer and a lender. The lender provides the big chunk of money today (that big amount that the consumer didn’t want to, or couldn’t spend) and the consumer agrees to make payments back to the lender over time. An example of this that almost everyone will be familiar with is auto financing (i.e. car payments).

A mortgage is simply the financing of a home.

Like an auto loan, a mortgage allows the consumer to legally own the underlying asset (car, home). Like auto loan paperwork, mortgage paperwork allows the lender to take back or “repossess” the underlying asset (aka “collateral”) if the consumer doesn’t pay as agreed, although the process is much more complex and time consuming. The idea is that if a consumer isn’t willing or able to honor the agreement, the lender can recoup some or all of their initial investment by taking the collateral (i.e. home, car) back and selling it.

What’s in it for the Lender?

Lenders don’t tend to lend money simply because consumers want loans. Lenders make money by offering loans because there is typically an interest rate attached to the loan.*

*0% auto financing is a notable exception, but that’s typically only offered via factory financing in order to sell more cars. Also, as you’ll see below about upfront costs versus monthly payments, a 0% payment rate doesn’t necessarily mean a consumer is being charged 0% interest overall. For instance, the auto buyer with the 0% loan may have had to choose that loan over, say, a $1500 cash back incentive. In that case, the buyer effectively paid $1500 in interest upfront in exchange for paying less over time.

Interest is additional money beyond amount borrowed that allows the lender to profit from the transaction. In the mortgage world especially, interest and interest rates are fairly complex topics. Reading more below will help you learn as much as you want to know about mortgage rates. (Possibly even more than you want to know)

Mortgage Rates 101, Part 2: Basic Parts of a Mortgage

Mortgage rates are interest rates on home loans.

There are really TWO mortgage rates:
The interest rate (or “note rate”) applied to your loan amount (or “principal”) and the rate implied by certain upfront costs (the “effective rate”).

APR (Annual Percentage Rate) attempts to convey that “effective rate.”

Understand the tradeoffs between upfront costs and payments over time.

Principal (definition): the current balance of a loan/mortgage. In the absence of any additional costs or fees, the initial principal balance of a mortgage is whatever was borrowed to buy the home. Let’s say you buy a $200,000 home and are able to make a $10,000 down-payment (an upfront payment that reduces the amount of money borrowed). The principal in this case would be $190,000.

Principal also refers to the remaining balance after a mortgage payment. Each payment is typically contains some interest for the lender and can also contain property taxes, homeowners insurance and mortgage insurance. Whatever is left over goes toward reducing the principal balance (the amount you owe, which is slightly different from a “payoff balance”). In other words, as you make payments, the amount you owe decreases. When that amount reaches zero, you own the home outright!

Payoff vs Principal: If you’ve refinanced or sold a home before, you may have noticed that the amount required to pay off the old mortgage was slightly higher than the principal balance on the mortgage. This occurs because your monthly mortgage payment covers interest charged during the previous month. If you pay-off your loan in the middle of any given month, the lender hasn’t yet collected interest for that month. They’re not going to charge you for the entire month, however, only the number of days between the 1st of the month and the payoff date.

For example, your mortgage payment on June 1st would cover interest for the month of May. If you pay off your loan on June 10th, the lender has not yet been paid interest for those 10 days, and will add them to your payoff amount. This is true for both purchases and refinances. Many lenders charge a small additional fee to obtain the payoff balance for administrative costs associated with an early payoff.

Mortgage Rates are simply the interest rates applied to the principal balance, but there is an important distinction. What most people refer to as “mortgage rates” are actually only part of the equation. The more accurate term would be “note rates.” This refers to the interest rate on the promissory note (an official document that you’ll sign during the mortgage process).

Think of the promissory note and the note rate as a sort of baseline for the overall cost of financing. While it’s true that the note rate is 100% responsible for determining the monthly mortgage payment, it’s typically NOT the only cost of financing. Most mortgages have an “upfront cost” component.

Upfront costs are charged by multiple parties (examples include: lender, appraiser, credit bureau, local government taxes, homeowners insurance companies, attorneys/title company, etc.) Most of these costs will not change regardless of the loan type or the lender, but some will.

Upfront lender-related fees are common. They add to the overall cost of financing. Therefore, the NOTE rate differs slightly from the actual or “effective” rate you’re paying on your money.

The Truth In Lending Act stipulates that lenders must quote that effective rate in the form of APR or annual percentage rate. If you don’t read anything else on APR, it’s important to know that not all lenders calculate them the same way, and APR can’t necessarily be trusted as an apples to apples comparison between two or more lenders.

For the purposes of understanding mortgage rate building blocks, we’ll simply use the term “upfront costs.” Whether we’re talking about the interest portion of your mortgage payment or upfront lender-related costs, it’s all money that ends up going from your wallet to the lender. In most cases, you have some say in dividing up the lender’s upfront income versus their income over time.

For instance, you will typically have the option to pay more upfront in exchange for a lower interest rate. The industry has long referred to this type of extra upfront payment as “points” or “discount points.” Despite any negative connotation from certain financial media pundits, points are neither good nor bad--simply a choice to pay now or pay later.

Only you can decide which way makes most sense for your scenario. The only thing that really matters is the trade-off between the two choices.

If you invest your extra cash and earn a certain rate of return, you may be better off minimizing your upfront costs and putting that money into your investments.

If, on the other hand, you wouldn’t be earning a great return on that money and you know you’ll have the mortgage for a long time, it may make sense to “buy down” the rate with additional upfront cost.

Your lender should be able to show you the difference between those options in terms of the number of months it will take to break-even on the additional upfront cost. For example, you would pay $1200 in extra upfront costs and $14 less per month in scenario B. It would take 86 months to break even because $1200/$14 = 86.

SCENARIO A: Upfront costs: $5000 Payment: $2000 per month
SCENARIO B: Upfront costs: $6200 Payment: $1986 per month

86 months (or 7.16 years) is a fairly typical break-even time frame when you buy-down your rate. Break-evens vary from lender to lender and from rate to rate. In cases where the break-even time frame is 4-5 years or less, it’s an increasingly compelling option for people who plan to keep the new mortgage for a long time and who don’t have a great place to earn a high rate of return.

The bottom line is that it’s your choice and there’s no right or wrong way to do it.

In terms of understanding mortgage rates, the important concept is that of “upfront cost” vs “cost over time.” For any interest rate you hear about or see online, there are certain assumptions underlying that quote. It could be based on higher upfront costs than you had in mind or a higher credit score than you have. Read more about how credit and other individual factors can affect rate. You won’t ever be able to know the actual rate until you know what those assumptions are.

NOTE: In lieu of choosing a mortgage with a higher rate and lower upfront costs, you may be able to increase the new mortgage balance in order to pay the costs--sometimes referred to as “rolling in.” This would keep the interest rate the same, but the payment would still be slightly higher because the loan balance is slightly higher. You’d also need to consider the fact that you’ll have more principal to pay off when it comes time to sell or refinance. Even then, this can sometimes be a more appealing option than raising the rate to cover the costs--especially if the upfront cost savings happens to be minimal between the quoted rate and the next rate higher (remember, they vary from rate to rate and lender to lender).

Mortgage Rates 101, Part 3: What is an APR?

APR attempts to factor in upfront costs to deliver a true “cost of financing” which is typically higher than the interest rate on your mortgage.

APR relies on human input and variables that can be manipulated to a certain extent. Thus, it’s an imperfect measurement.

A slightly lower APR from one lender may not necessarily be a better deal.

Before reading this section, make sure you’ve read about “upfront costs” in the mortgage rate definition section (Part 2). Some upfront costs associated with a mortgage are considered “prepaid finance charges” in that they are only paid in order to obtain the mortgage and NOT tied to a tangible service.

EXAMPLE: Homeowners insurance is a tangible product that could (and should!) be paid for regardless of the presence of a mortgage. Therefore, it’s NOT a prepaid finance charge. A loan processing fee, on the other hand, is only something you’ll pay if you’re getting a loan and therefore IS a prepaid finance charge.

Prepaid finance charges (or PFCs) are neither good nor bad. They are not scandalous or uncommon. A loan without them isn’t necessarily a better deal than a loan with lots of them. And even if you’re told you’re not paying PFCs, most of them will still need to be paid by someone. Typically, this involves the lender offering a higher interest rate and then paying the PFCs for you. In that example, you’ve simply financed the PFCs by paying higher interest over time. Again, that’s neither good nor bad--just a choice between paying more upfront or more over time.

PFCs are most notable because they determine annual percentage rate (APR) of a loan. Lenders are required by law to disclose APR. This is a good idea in concept, but not so simple in practice. Regulators figure the requirement levels the playing field by forcing lenders to give consumers an idea of what the true cost of financing will be.

Indeed, the notion of quoting mortgage rates in terms of NOTE rates and upfront lender-related costs is fantastic and ideal. Unfortunately, regulators leave it up to lenders to do their own APR calculations. While most lenders do things the same way, others do things differently in order to quote a lower APR than their competitors. Some lenders are simply more conservative in what they define as a PFC because they want to avoid regulator scrutiny. Those lenders may have higher APR quotes than others even if every single upfront costs is exactly the same.

Bottom line, APR is not necessarily apples to apples. You shouldn’t blindly trust one lender’s APR over another. As tedious as it may be, the best way to compare quotes is to see what the upfront cost assumptions are line by line.

Mortgage Rates 101, Part 4: How Are They Determined?

Mortgage rates are driven by investor demand.

Investors view mortgages as similar to bonds (lower risk, more stable return).

Unpredictable consumer behavior makes mortgages more risky than “guaranteed” bonds like US Treasuries.

Investors expect higher rates of return for riskier scenarios (i.e. lower credit scores = higher mortgage rates, etc).

We’ve covered the building blocks of mortgage rates. Now let’s discuss where mortgage rates come from. How are they decided? Why can they change? Why can they be so different from person to person?

SIMPLE VERSION: At their most basic level, mortgages are like bonds (fixed-income investments where an investor fronts a lump sum and is paid back over time with interest). There are many types of bonds in the bond market and those that are similar to each other tend to move in the same direction based on investor demand. Movement in the bond market generally translates to movement in mortgage rates.

From there, lenders make additional adjustments to rates based on things like credit scores, down-payment amounts and other risk factors. Those adjustments rarely change, so day to day movement in an individual rate quote is almost always determined solely by bond market movement (unless your credit score rapidly changes or you decide to put a different amount of money down).

DETAILED VERSION: As discussed in Part 1, the existence of mortgage rates depends on investor demand. At the simplest level, someone with money has to be interested in giving it to you so you can buy or refi a home and pay them back with interest over time.

Given that the investor could buy other investments (stocks, bonds, currencies, etc.) something about your mortgage has to get their attention. There are several pros and cons of investing in mortgages, but the most important factor is that mortgages offer a competitive rate of return without much more risk, compared to similar investments.

When I talk about similar investments, a mortgage would be most similar to a bond. A bond is considered a “fixed-income” investment because an investor pays a lump sum upfront in exchange for a fixed schedule of payments over time. Payments could occur monthly, semi-annually, etc.

Unlike most fixed-income investments, the borrower in the case of mortgages is a consumer. Contrast this to the biggest category of fixed-income borrowers: entire countries! For example, when it comes to US Treasury notes and bonds the borrower is the United States Treasury.

While the US and other major borrowers make debt payments for a guaranteed amount of time, consumers have choices when it comes to their mortgage. Consumers can CHOOSE to refinance or sell. That means the investment is retired. The investor gets their initial principal back and perhaps some of the interest they’re entitled to for the current month, but no further monthly payments. This could happen weeks, months, or years into a mortgage.

Other situations like foreclosure or short sale also prematurely end a mortgage. In some cases, the investor could lose some of their initial principal, but due to the structure of the mortgage market, that’s a rare occurrence these days. The unpredictable nature of consumers selling or refinancing is a much bigger issue.

Why would an investor care about getting their principal back early? Simply put, the investor is counting on making their money by collecting interest over time. In fact, investors often pay a premium for the right to collect monthly payments on a mortgage. If something cuts those payments short, the investor could LOSE money.

Here’s a practical example showing why an investor wouldn’t want to be paid back early:
$100,000 = Mortgage Loan Amount (principal)
$104,000 = What an investor might pay a mortgage company to obtain the loan.

In this example the principal balance is still $100k. The investor paid a premium to obtain $100k of principal because the interest rate was attractive relative to other investment opportunities. The investor could have paid nothing for a loan with a substantially lower rate, but this rarely happens in the modern mortgage lending environment. Naturally, any time before the total amount of interest in the above example reaches $4k, the lender would like the borrower to continue making payments.

It’s worth noting that most mortgage transactions don’t simply involve one investor buying one mortgage. Investors will either buy lots of mortgages (so they are more likely to have plenty of mortgages remaining even if a few of them are paid back early), or they will simply buy a chunk of the same sort of portfolio. When multiple, similar mortgages are grouped together and sold off in those “chunks,” it’s a process known as securitization.

Mortgage Rates 101, Part 5: What Causes Mortgage Rates to Change?

Mortgage rates change daily, and sometimes multiple times per day. In this section, “mortgage rates” will refer to the combination of upfront cost and actual interest rate described here:
The 2 Components of Mortgage Rates. For example, if we talk about “higher rates,” it could either mean that the interest rate is higher, or simply that the upfront cost is higher for the same interest rate.

These frequent changes are not arbitrary in any way. Instead they are the result of multiple factors with varying levels of importance and interdependence. Mortgages exist because investors want to earn interest by offering loans. Because of this, mortgage rates end up being directly driven by all the various market forces and operational considerations that dictate what those investors can/should/must charge.

Factors relating to market forces much like mortgage borrowers need money to buy a home, the US government needs money to finance Federal spending. Political commentary aside, this creates a massive market for government debt, which in turn serves as the plainest, most risk-free benchmark for many other types of debt. Collectively, this is known as “the bond market.”

There are many other types of bonds with varying levels of risk and different features. They all exist because investors need or want to lend money and various entities need or want to borrow money. Mortgage borrowers are one such entity. When lenders have enough of the same type of loan from mortgage borrowers with similar circumstances, those loans can be grouped together to form a bond that can then be sold to other investors. Once the mortgage lender sells those loans to other investors, they now have the cash flow to go make new loans—assuming there are other investors who are interested in buying more loans.

Thus, a market for these mortgage-backed-securities (MBS) is born. It’s quite a bit more complex in practice, but generally speaking, it’s simply a market for groups of loans. These trade on the open market and tend to follow the broader movements of more mainstream bonds like US Treasuries. In short, all the factors that can affect interest rates in the bond market can also affect the price that investors are willing to pay for these groups of mortgages. Those prices have a more direct influence on the rates that mortgage lenders can offer than anything else!

Bottom line: loans become mortgage-backed-securities which trade on the open market, and the prices of mortgage-backed-securities dictate the rates that lenders can offer to new mortgage borrowers.

Factors relating to operational considerations knowing the price that investors are willing to pay for a group of similar mortgages gives lenders a baseline for the costs they must charge borrowers. The lender’s operational considerations will account for the rest. These considerations are all directly or indirectly related to how much profit the lender wants to make or how much business they are capable of doing.

For instance, we tend to think of banks as always being available to make loans to borrowers who fit the right criteria, but that isn’t always the case. Many mortgage lenders have a certain amount of cash flow that they’d ideally like to use over a certain time frame. If a lender isn’t on pace to lend as much as they’d like, they might lower rates in order to entice more business. Conversely, if a lender is on pace to lend out more money than it has, it could raise rates in order to deter business.

Apart from the availability of funding, lenders must also consider the availability of personnel. It takes human beings to make loans happen, and at a certain point, a lender will be at capacity. It can then either hire more staff or simply raise rates to throttle the amount of incoming business.

These are two of the most basic operational considerations for lenders that complement the actual market-driven prices of mortgages. This can be thought of as any sort of business that sells a product made from raw materials. A car company, for example, is greatly affected by the cost of steel and aluminum, but the cost that buyers end up paying is also greatly affected by how that car company does business. How many factories do they have? How well-trained are their employees? How efficient are they?

In the mortgage world, mortgage-backed-securities would be like the steel and aluminum while individual lenders would be like auto manufacturers, each trying to build/sell cars as efficiently and as profitably as possible.

Bringing it all together, the lender-specific considerations certainly change and certainly account for a portion of any given mortgage rate offering. Quite simply, this is why different lenders offer loans at different rates even though they’re all working with the same raw materials.

But it’s those raw materials—those mortgage-backed-securities—that move throughout the day and do most to affect the moment-to-moment changes in lenders’ rate sheets. If something in the world is happening to cause investor demand to increase in bond markets, MBS tend to benefit as well. When MBS prices rise, investors are willing to pay more for those bundles of loans, meaning that lenders may be able to offer lower rates. Conversely, if investors are seeking riskier investments for whatever reason, MBS prices could fall, meaning investors aren’t paying as much for mortgages, thus forcing lenders to raise rates.

Mortgage Rates 101, Part 6: Locking Your Mortgage Rate

At some point during the mortgage process, the contract interest rate (the one that ends up on the Promissory Note--the most official document stipulating the terms of repayment) must be “locked.” This means that there is an agreement between the borrower and the lender regarding what the contract rate will be. The rate-lock will also specify a date by which the mortgage must be closed and funded.

Rate Lock Time Frames
Rate lock time frames can vary. Historically, the most common time frame had been 30 days. The regulatory changes of the post-meltdown era caused slightly longer turn-times for the various steps in the mortgage process, resulting in an increased prevalence of 45 and 60-day lock times. There are shorter and longer lock time frames as well, depending on the lender. These include, but are not limited to 10, 15, 21, and 90 days.

In some scenarios, or among certain lenders, the borrower doesn’t have any input as to when and for how long the rate will be locked. The borrower may either agree to the lender’s lock policy or take their business elsewhere. In most cases, however, there is a certain degree of liberty when it comes to choosing “when” and “for how long” to lock. In these cases, mortgage originators will help manage expectations as to how quickly the process can be completed, with the generally understood goal being to set a lock window that leaves plenty of time for the loan to fund, but that also isn’t unnecessarily long.

Cost Considerations
Why wouldn’t we want a lock time-frame that’s unnecessarily long? Bottom line: the longer the lock window, the higher the cost. When it comes to the mortgage process, costs associated with your rate can take the form of changes to the rate itself or changes to the upfront cost (discount or rebate) associated with that rate. Locking the same rate for longer means that the discount cost will be higher or the rebate will be lower. The relationship between days of lock time and cost isn’t always exactly linear, so it can make sense to weigh the risk and reward of various time frames.

When To Lock
There’s no universally correct answer to the question: “should I lock or float.” It’s one of the most thought-provoking and complex topics in the world of mortgage origination. There are too many variables for one methodology to be applicable to every scenario. It goes without saying that locking as early in the process as possible will always be the safest option for the borrower. It’s also unequivocally true that it’s historically the least profitable option on the average day from 1980 on. That said, this is only the case because interest rates have generally been moving lower since 1980! Not only that, but there have also been many times since 1980 where rates have risen brutally, in spite of the longer-term trend. In many of those cases, borrowers that failed to lock early enough in the process were either forced to accept a higher rate or simply never completed the process.

Purchase and Refi Lock Considerations When we talk about “never completing the process,” this could naturally be a very big problem in some cases. For example, rates can rise quickly enough that many borrowers can no longer qualify for the monthly payment. If they’re not locked, they simply cannot complete the mortgage. In the case of purchases, that could mean they just lost their earnest money deposit--not to mention the opportunity to buy the house they wanted or needed. Even in the case of refinances, failing to complete the mortgage can mean the loss of significant monthly savings or in more dire cases, much-needed cash for any number of purposes.

Because of these potential pitfalls, it’s almost universally wise to heavily consider locking as soon as the monthly payment and lock time frame make sense for your scenario, and to only forego locking if you’re prepared for the increased costs associated with an unforeseen rise in rates. If such a rate rise would jeopardize your qualification for the mortgage or even your willingness to complete it, locking is the only option.

Lock Extensions and Expirations
Despite the best intentions and diligent participation among all parties, some mortgage are destined to run past their initial lock time frame. While there is no universal policy, most lenders are able to extend the lock time frame based on certain conditions. Most of the time, this will involve a predetermined cost, and in many cases, this is simply the difference in cost between your original lock time frame and the next tier. For example, if there was a 0.125% change in the discount points in order to lock for 60 days instead of 45, and assuming you locked for 45 days only to find it wasn’t going to be long enough near the end of the process, extending to the 60 day lock could be as simple as adding the 0.125% to your upfront costs in order to extend the lock for 15 days.

In other cases and depending on the lender, the situation can be far more severe--especially if rates have moved significantly higher since you first locked. It can absolutely be the case that going over the originally-agreed-upon lock time frame means that your loan will now have “worst-case” pricing. This means that you have to pay whichever is higher between the original cost of the lock time frame needed to complete the loan or the current market rate. If we’re only talking about something like the 0.125% from the previous example, that’s not a big deal, but if rates had moved significantly higher, that cost increase could easily be over 1.0%--enough to make anyone wish they’d chosen the longer lock window upfront.

Mortgage Rates 101, Part 7: Securitization and MBS

Understanding securitization (mortgages turn into bonds)

Securitization makes rates lower and allows them to follow other bonds more closely.

There are a few ways investors could address the unpredictability problem associated with consumer behavior. They could either buy so many mortgages that their average loan lasts for an average amount of time OR the industry could create a standardized product that accomplishes the same goal and offers additional protections.

Enter: Mortgage-Backed-Securities.

Mortgage-Backed-Securities (or MBS) are what groups of similar loans turn into in order to be sold, bought, and traded. This process is known as “securitization.” To understand securitization, let’s consider a hypothetical scenario:

20 investors each buy 1 mortgage with a $200k principal balance. 1 of those loans will pay-off early and the investor will lose out on interest they would have otherwise collected (i.e. they’ll lose money) Conclusion: 19 investors made good money. 1 investor lost good money. In that example, there was no in-between when it came to lender profitability, and no major differences between the 20 underlying loans. It was luck of the draw getting stuck with the one consumer who decided to sell or refinance. The other 19 investors are glad it didn’t happen to them, and they’d all be willing to give up a fraction of their profits in order to make sure it never happens to them. They’d love to have a way to equally share the risk--to have a 100% chance of small loss as opposed to a small chance of a big loss.

Securitization makes this risk-sharing possible. Using the example above, here’s a simplification of how it works:

The 20 loans are all evaluated based on a set of standards that ensures a certain level of similarity (i.e. loan amounts in a certain range, credit scores over a certain amount, all loans used to purchase a primary residence, all borrowers within a certain range of debt vs income). An agency that specializes in verifying all of the above stamps them with a seal of approval that allows them to go into 1 pool of mortgages. That pool is now like one big mortgage that allows investors to buy smaller chunks. If the average loan amount is $200k, then the same 20 investors could spend the same amount of money and buy the same 20 mortgages, only this time they’ll all share in the loss if 1 out of 20 loans pays off early, and they’ll all benefit from the high likelihood of 19 out of 20 remaining profitable. Moreover, by spreading the risk out and by using past precedent, they can reasonably estimate that 1 out of 20 will pay off early and adjust their purchase price accordingly.

To understand why this is the case, imagine being offered a chance to buy one envelope that had a 95% chance of containing $100. How much would you pay given a 5% chance it would be empty? Now imagine 2nd envelope that had a 100% chance of containing of containing $95. Would you pay more?

Naturally, most people (and most investors) would pay more for the 2nd envelope. By paying less for the first envelope, you’d be like a lender charging more money for additional uncertainty.

The point is that the more certain lenders can be about risk and the more evenly it’s spread out, the less they have to charge to account for it. In this way, securitization helps rates stay lower than they otherwise would be.

Securitization also makes for a more standardized product. This standardization means more investors are comfortable buying mortgages without personally evaluating each underlying loan. After all, those loans have had to pass through the same set of standards from an agency like Fannie Mae, Freddie Mac, The Federal Housing Administration, The Department of Veterans Affairs, etc.

Imagine every tangerine at every grocery store being exactly the same. You’d have a really good idea of what you’d pay and what you could expect to get. You could even grab a whole bag of tangerines without having to check each one.

A bag of tangerines in that example would be like a group of loans underlying a mortgage-backed-security (MBS). The price of tangerines would be like the price of MBS.

If grocery stores had a surplus of tangerines , they might lower the price. Because you know exactly what you want to pay for tangerines, you’d see the good deal and take advantage of it. You’d be less likely to do so if you had to wonder how those tangerines tasted (maybe they’re on sale because they’d sub-par?!).

Conversely, if there was a spike in demand for tangerines, prices might rise, and you might only buy them if you absolutely had to have them.

But just like tangerines aren’t the only fruit in the produce aisle, MBS aren’t the only fixed-income investment in town. In fact, there’s an undisputed gold standard in the bond market: US Treasuries. Backed by the full faith and credit of the US Government, the US would have to be bankrupt in order for investors to not be paid back as expected. Treasuries are the regular old navel oranges of the bond market.

Just like the supply and demand for tangerines could even be affected by the supply and demand for oranges, MBS prices are influenced by movement in Treasury prices.

This relationship between US Treasuries and MBS is at the heart of interest rate levels and movement. The produce aisle would be like “the bond market.” Investors want to buy a certain amount of bonds for certain reasons just like grocery shoppers tend to buy a certain amount of produce. Sometimes it’s oranges. Sometimes it’s tangerines. Sometimes they’re just not in a citrus mood.

So How Does Securitization Affect Mortgage Rates?
Understanding securitization and MBS is important in understanding what moves mortgage rates for a few simple reasons. Securitization turns groups of mortgages into a commodity that can trade on the open market like other bonds. From an investor standpoint, these mortgage-backed securities (MBS) are very similar to other investment options in the bond market. Thus, whatever causes movement in broader bond markets tends to cause similar movement in MBS.

As MBS prices rise, it means investors are willing to pay more to obtain mortgages. There’s an inverse relationship between price and rate. The more an investor pays, the lower a mortgage rate can be. If that’s confusing, just think of it like this: whether we’re looking at the beginning of a mortgage or the payments over time, there is CASH FLOW between the borrower and the investor. If the investor wants more money today than they did yesterday to do your mortgage, it means they’re either charging a higher interest rate, or paying your lender less upfront to buy the rights to the loan. By that same rationale, instead of paying more to buy the rights to the loan, the lender could instead lower the interest rate. Either way, there would be a decrease in cash flow to the lender.

Mortgage Rates 101, Part 8: Overview / Conclusion

This is it! Like the first time you fully grasped the “Bill on Capitol Hill” song, this section will hopefully help you understand the full lifecycle of a mortgage rate from the sparkle in an investor’s eye to the monthly payment being made. In order to get the most out of what follows, please make sure you've read everything above this section. Mortgage rates begin with you. Either you don’t have or don’t want to spend the cash to buy a home outright, so you’ll need a loan. You could get other loans from other places (borrowing against a 401k or life insurance plan, for instance), but for vast majority of people, a mortgage is the only viable option.

You have now created demand in the mortgage marketplace. You are willing to take on debt and pay interest over time. You are what many investors are looking for!

“Investor” is a broad term. In fact, if you have any investments that are managed funds (like a 401k), and if those funds have a “fixed-income” component, it’s quite possible that a percentage of that fund is allocated to bonds that are backed by mortgages. In that sense, even you are part of the “investor” side of the equation. The important part is that there is “money” out there looking for a home where it can generate a return for investors.

Most mortgages become investments via the securitization process. A government agency (or government-sponsored enterprise, like Fannie Mae and Freddie Mac) sets certain standards for loans it will insure. The agency also provides a framework that mortgage companies can use to evaluate (or “underwrite”) your loan scenario. If your scenario makes it through the agency’s hoops, your eventual mortgage is eligible to become part of a pool of similarly eligible mortgages. Mortgages grouped together in this way are called Mortgage-Backed-Securities or MBS.

MBS carry guarantees from one of the agencies mentioned above. These guarantees protect the investor in the event the mortgage borrower doesn’t make payments for any reason, and ensure they’ll receive all the interest and principal they would have otherwise received for as long as the underlying mortgage exists.

A tomato soup analogy:

It takes more than 50 independent commercial tomato growers to fuel operations for Campbell’s main processing facility (which handles soup, pasta sauce, and V8, among other tomato-based products). Different tomatoes from different farms will ultimately end up mixed together and packed into the same product, provided they meet the standards of Campbell’s as well as the FDA. The price at which growers are willing to sell has an impact on what Campbell’s pays for the tomatoes. The level of demand on the tomato soup aisle is also a factor.

In this analogy, a tomato would be an individual mortgage. A grower would be like a mortgage lender who produces big groups of similar individual mortgages. If those tomatoes/mortgages meet certain standards, they can be sold to someone like Campbell’s or Heinz (analogous to a large mortgage investor like Wells Fargo or Chase). This business relationship creates a wholesale marketplace for “large quantities of a certain product that meets certain standards.” The big players expect a few tomatoes/loans will be better or worse than the others, but because such large quantities are mixed together, the final product remains very consistent and predictable. If several of the tomato plants from a farm that sells to Campbell’s had really awful-tasting tomatoes, you would never know it by the time it gets to your table.

Whether we’re talking about tomatoes or mortgage loans, the logic is the same. When we have a high number of individual units meeting the same standards--especially when those units are destined to be mixed together anyway--it’s easy to establish a standard price at any given time based on supply and demand. It’s this price that has the most direct effect on what you’ll pay for tomato soup and the interest rate you’ll pay on your mortgage.

This “going rate” that big investors are paying for pools of mortgages (or in analogy terms, what Campbell’s and Heinz are paying for a truckload of tomatoes) is quite simple the price of a certain category of mortgage-backed-securities. These are essentially bonds with either an explicit or implicit guarantee from the US government. That means MBS prices move up and down with a high degree of correlation to the price of other government bonds of similar lengths of time.

The catch is that the consumer mortgages underlying the mortgage securities can be paid off any time (selling, refinancing, foreclosure, short sale) so they provide less predictable cash flow for investors than US Treasuries which will keep paying the same amount throughout their lifespan. The implication is that the average life-span of a pool of 30yr fixed mortgages ends up being in the neighborhood of 6-11 years depending on the real estate market and whether or not rates drop enough to cause a surge in refinancing.

Investors aren’t willing to pay as much for loans with cash flow uncertainty. If I have $100 dollars to invest in Treasuries or MBS, I’m going to expect a slightly higher rate of return on the MBS, because if a fifth of the loans in that pool of MBS refi or sell, then I’m left collecting interest on only $80 whereas if I’d bought the Treasuries, I could be assured of a lower rate of interest for the entire term.

This brings us to the first core concept of what drives mortgage rates: they tend to move a lot like US Treasuries of similar durations. What an investor loses in utter cash flow certainty, they gain in a higher rate of return. If that rate of return looks like a good deal compared to Treasuries, demand for MBS increases, and the effective rate of return falls. Vice versa if MBS returns look weak compared to Treasuries.

While it varies over time, the gap between a 10yr US Treasury yield and the average top-tier 30yr fixed mortgage rate quote has maintained a range of 1.55-2.0% since September 2012. More than any other factor, this is the foundation of the first several percentage points of any mortgage interest rate (in other words, take the 10yr Treasury yield and add 1.5-2%). That’s it. That’s the baseline. From there, it’s really just fine-tuning based on variables pertaining to you and your lender.

Lenders vary somewhat with respect to what they can/will offer in terms of rates. This can be affected by profit margins, number of employees, advertising/legal costs, and other factors that affect overall efficiency. A lower rate isn’t necessarily a better deal if there’s a higher risk that something unexpected happens during the course of your transaction. Plenty of mortgage-seekers have had amazing experiences paying a rock bottom rate to a highly efficient operation without getting a ton of one-on-one time with their loan officer. Plenty have had amazing experiences paying higher rates because it afforded a higher level of customer service. To be sure, some companies are just better than others, as they represent a sweet spot that balances the many factors driving the final cost of the loan. It’s equally true that some loan officers are better than others even inside the same company.

There are several reasons you might end up getting a loan quote from any given mortgage company. Maybe you get several. During this process, keep in mind that the mortgage company can only control the rates and fees that it charges. There are other fees associated with a mortgage. Frustratingly, it’s up to the mortgage company to quote those other fees as well. Some of them are more careful about underpromising and overdelivering on affordability. Others will attempt to minimize the appearance of 3rd party fees (the stuff you’re going to pay no matter whom you choose to do your loan) in order to give the appearance of a more competitive quote. When it comes to hard numbers, the ONLY basis for a direct comparison of one company’s rate to another is the interest rate itself and the fees charged by the mortgage company itself. From there, it’s up to you to decide how much value to place on trust, customer service, and other non-monetary considerations.