How is the Mortgage Rate Determined?

Wonder how the rate of interest on mortgages are decided? And why are they different for different people and mortgages? With this article we try and resolve these queries.

Risk Factor Affects the Rate of Interest

What’s life without a little risk? That may sound cliché, but to grow and go beyond the limit of your financial reach, its essential to take financial risk and some sort of gamble. You may need a job to make a living and to get a well paying job, formal education may be required. There might be need for a vehicle, to get to work. To try to be monetarily sensible in the long run, you may decide it’s best to invest in a house. But as education, a car or a house are so expensive, it usually requires taking out a loan to buy either of them.

Now, taking a loan is a matter of risk, but it is not only you that is  taking a risk. The lender is risking his money on you. There is also a cost of buying or renting anything and Interest rates are the cost of borrowing money and an insurance for the lender in a way. Usually, higher is the risk of lending, the cost of borrowing money is also higher. However, if you are charged a higher interest rate, it should not be taken personally. You are not the only one that is being taken risk upon – its the economy as a whole that the risk is being taken on. You probably are an excellent sales personnel in a Automobile Showroom. But in case the market descends and the automobile sector suffers, you might be laid off. It is important for the lender to consider any such risk, despite your awesome credit history and financial situation. Putting it simply, based on how much of a risk the lender thinks he is taking on you and the economy, interest rates are determined.

Having cleared the basic logic behind interest rates please be informed that mortgage rates are however, far more complex than this. A mortgage as we know, is a loan on a house and mortgage rate therefore, is the rate of interest charges on such a loan. One institution, such as a bank or a federal reserve can not be pointed out, that determines your mortgage rates. If we were to follow the trail we would eventually find an entangled and complicated web of elements that goes into how mortgage rates are determined. Lets have a look at what process takes place behind the curtain, that we don’t see.

Impact of Secondary Mortgage Market Rate

It is popularly believed that the lender that grants you the loan for house, holds on to it. This is not true though. On the contrary, it enters the secondary mortgage market, as they call it. What happens here is :

  1. Your mortgage is sold to a large, third party investor, known as the aggregator – normally a mutual fund or an institutional investor.
  2. Your loan, then is packages along with several other loans in to MBS, i.e., Mortgage-Backed Security.
  3. MBS is then divided into shares, called as tranches, to further sell to other investors.
  4. Tranches are bought by these final investors in order to receive a return on investment, which comes from the mortgage payments of the homeowners. The lender and aggregators, therefore are middlemen in the whole process and try to balance interests between the buyer and investors. Lower interest rates attract the home buyer and higher rates attract the investor, both sides being highly competitive.

Knowing this now, is it pretty safe to say that the secondary mortgage market is what determines the mortgage rates? In a way, the price that aggregator is wiling to pay to lender for the loan, determines the mortgage rate. But wait – that price is based on what amount the investors are willing to pay for the tranches of mortgage-backed security(MBS). Investors therefore, mainly determine the mortgage rates. So, when investors decide how much and at what price they should invest in MBS, what drives those decisions. Lets see

Economic Factors Influencing Mortgage Rates.

We now know that the risk factor and secondary mortgage market are major influences when it comes to mortgage rates. But there are several factors that come into play when investors decide on how much they what to invest in tranches of MBS. These factors include, rate of inflation, the price of US treasuries and the Federal Reserve. Lets take a closer look at how these affect the mortgage rates.

Taking of Inflation, it is the phenomenon of rise of prices of common goods and
services throughout the economy. When inflation is moderate and consistent, its a sign of a healthy economy and usually influences proportionate rise in salaries and wages. For lenders however, it comes as a problem. It means actually, that the amount of money, borrowed by people now, will be worth less by the the time it is paid back. Investors therefore insist on higher mortgage rates to cover the losses when rise in inflation is predicted by the economists.

Investors have many choices to decide from while investing their money. Competition among the investments also affect the mortgage rates. While, MBS are compared to bonds and other financial instruments, investor often compares them against U.S. treasuries. To tickle the interest of the investor, the return on MBSs has got to be even higher, because U.S. treasuries are safer investments.  The Fed(Federal Reserve), directly or indirectly influences some interest rates, especially the federal funds rate which also, indirectly affect the mortgage rates. Federal Funds Rate, is the interest on overnight loans taken by banks, to meet the end-of-day requirements. Raising this, lowers the supply of available money by making borrowing more expensive. This helps to stop a rise in inflation. Reversely, lowering the rate increases makes the borrowing inexpensive and increases supply of money encouraging inflation. These adjustments, clearly have wide ripple effects that they eventually influence determining the rate of mortgages.

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