The "Loan Xperts" Blog

In an article written by Walter Updegrave, Editor of Money Magazine, he explains in detail a commonly confused question:

How are mortgage interest rates determined, and what indicators can I watch to better understand where mortgage rates are headed?

Put the first part of your question -- What or who determines mortgage rates? -- to a couple dozen people and I think you'd quickly come up with a list of usual suspects: it's the banks, or the mortgage brokers, or the big mortgage packagers like Fannie Mae or Freddie Mac or maybe even Ben Bernanke and the Federal Reserve. And each of those answers is partly, but not exactly right.

In fact, it's all those things, and many more, including you, me and everyone else in the market for a mortgage or looking to invest money, who ultimately set mortgage rates.

I know that may sound kind of vague and loosey-goosey, maybe even nonsensical, so let me explain.

Basically, when you take out a mortgage, a bank, mortgage company or other mortgage originator is making you a loan at given interest rate. Sometimes the firm that makes the loan holds onto it.

But more often than not, the lender or mortgage originator sells that loan to an institution that packages it with other mortgages into what's known as a mortgage-backed security and then sells that security to investors. That investor, whether it's a mutual fund or a large institutional investor, earns a return by collecting the principal and interest payments that you and all the other mortgage borrowers make.

In order to get investors to buy those mortgage-backed securities, they must pay rates of interest that are competitive with alternative interest-paying investments such as Treasury bonds.

You might figure that, since a 30-year mortgage has the same term as a 30-year Treasury bond, mortgage rates might track the rates on long-term Treasury securities. In fact, 30-year mortgages remain outstanding on average about 10 to 12 years, so rates on 30-year mortgages tend to track the yields on 10-year Treasury notes.

Of course, since you and other mortgage borrowers aren't as good a credit risk as Uncle Sam, rates on mortgages are somewhat higher than those on 10-year Treasuries. In general, 30-year mortgage rates are about two percentage points higher, but that spread can vary depending on the supply and demand for Treasuries and mortgage-backed securities as well as a number of other factors.

One other crucial element that helps determine mortgage rates is the outlook for inflation. If investors believe prices are likely to rise significantly in the future -- that is, inflation is on the rise -- then interest rates will rise as well.

The reason is that inflation dilutes the future value of the fixed interest payments the investors will receive. So investors will demand protection in the form of higher interest payments, which means higher rates for borrowers. On the other hand, if investors believe inflation will head down in the future, they're willing to accept lower rates.

I hope this quick blog has given you a little more insight into how mortgage rates are determined. We welcome your comments and/or questions, so please feel free to respond to this blog, and check back periodically as we update this section weekly with timely news about the mortgage industry.