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How Are Mortgage Rates Calculated?

mortgage rates

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You know you want a low mortgage rate. But have you ever thought about how mortgage rates are calculated? How do lenders come up with the rates they offer? The short answer is, it’s all about the bond market — namely, mortgage-backed securities (MBS).

Mortgage-backed securities

A mortgage-backed security is a group of mortgages that is sold on the secondary market to investors. The investors who own mortgage-backed securities are basically lending money to the borrowers who took out the loans. The investor collects the interest paid on the loans, making mortgage-backed securities a very good long-term investment.

MBS and the mortgage market

The relationship between MBS sales and mortgage rates is negative, meaning that when mortgage-backed security investing is high, mortgage rates are low. This is because when there is more money circulating in the bond market, lenders do not have to entice investors with higher rates. Higher interest rates are better for investors, but worse for borrowers. So what causes the bond market (and thus the mortgage market) to change?

Risk avoidance

Like any financial market, the bond market changes for many reasons. But one of the main factors that causes this particular financial market to fluctuate is risk avoidance. Because mortgage-backed securities are backed by the U.S. government, they are considered a very safe investment. This means that in times of international turmoil or uncertainty, foreign and domestic investors flock to the U.S. bond market. Demand may also rise in a time of domestic economic stress. So, as a general rule, mortgage rates will go up as the economy gets better and fall when the economy is doing worse. Average 30-year conventional mortgage rates are running about 3.5% right now, which is historically very low.

Common misconceptions

Some people believe that the 10-year Treasury note has an effect on mortgage rates, but this is not true. The 10-year Treasury note is a debt obligation issued to investors that matures in 10 years. It’s a way for the government to make money on a short-term basis. There is a correlation between the two over the course of years, but this has no effect on the day-to-day shifts in rates.

The Federal Funds Rate also has nothing to do with mortgage rates, contrary to popular belief. This is a mistake people often make because the Federal Reserve sets this rate. However, mortgage rates are not specifically set like the Federal Funds Rate. No one, not even the Fed, can set mortgage rates; though they can have an influence with open market operations.

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