Understanding residential mortgage rates in today's market

Today's market volatility in mortgage rates is due to real and perceived economical forecast and has little to do with the prime rate.  Unfortunately people hear that the prime rate is at 2% (the current level) and think that this is what mortgages rates should be. This is a miss conception that I will try to address in this article.

Several years ago the US Treasury would auction 30 T-Bonds and they were auctioned every 6 months and mortgage rates were based on the price of these T-bonds at the close of auctions.  The market price and its effective yield in the secondary market is what banks used to calculate the interest rate for a mortgage. The US Treasury stopped auctioning these types of instruments starting in 2002 and reinstated them in 2006.  The mortgage and financial institutions for a lack of any other long term treasury then used the next longest term notes,  the 10 year Treasury note,  as the instrument for calculating mortgage rates. It was believed that this would be the best instrument to use as its maturity date was shorter and would give a more realistic tool to calculate mortgages and reflect market conditions.

For our example we will use the 10 year note and a price of $100.00 and an initial interest rate at the end of the auction of 4%.   The next week in the secondary market the price to buy this note is now $105.00 and the effective yield would now be 3.40%. The very next week the same note sold in the secondary market at $99.50 the effective yield would be 4.06%. In these two examples you see that the yield moves in the opposite direction of the price to purchase the note.

Banking institutions use these prices and add 2% or more to the note rate for the purpose of quoting rates and this is the banks profits on the money they loan out. Banks can raise or lower their margin they add due to the bank's liquidity to fund and liquidity from the Federal Reserve to lend money.   

Mortgage rates are now more volatile in the last year because of market conditions that are affecting the investment community. Normally investors would move to the bonds and T-bills for safety because bonds are backed by the US Government and are considered very safe. Where this investing strategy falls apart is when there is fear of inflation or financial instabilities. This is the double whammy that the investor is seeing today with inflation fears and financial worries in Freddie Mac and Fannie Mae and they are fleeing the bond market. We learned earlier in the example above that the yield goes up when the price of the bond goes down and so the rate you see for a home loan also goes up.

In the short term, rates will move up slightly due to market volatility. For the next year ahead I foresee rates between 6.5% to 7%. Still this is in historical context over the last 25 years still a very good rate.  If you have a question about financing of lending questions. Contact me.