How Do "They" Determine What Average Interest Rates Will Be?

Dated: January 10 2024

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For the first time in a while, there is good news in the housing market regarding interest rates.  At the time of this writing, the average 30-year fixed mortgage rate has fallen from 8% to around 7%.  This is great news for home buyers as that reduces the monthly payment on the average-priced home by around $300/month! That's a massive saving for most households!  There are several big names out there that expect that trend to continue!  So, why are they coming down all of a sudden?  Who decides what these rates are anyway?  Let’s dive into some of the factors that influence mortgage rates so maybe, if you’re so inclined, you can make your own predictions for the future!

 

To start with, it’s important to understand what happens to your mortgage after you close on your new house.  Most of the time, your lender will sell your mortgage on the secondary market.  This means that the bank you were working with during your transaction sells your mortgage to an investor.  You may already know this since the company you write your monthly mortgage check to is not the same company you filled out your mortgage application with.  Now, no one has the time or desire to research each of the estimated 84 million mortgages that currently exist in the United States.  So, bankers will bundle a bunch of these individual mortgages into something called a Mortgage-Backed Security (MBS).  This may sound familiar if you remember the housing crisis of 2008 or the amazing movie The Big Short starring Steve Carrell and Brad Pitt.  (If you haven’t seen it, you definitely should check it out.  It does a great job explaining how we got into that 2008 mess!)

 

Ok, so we have a bunch of mortgages bundled together in a MBS.  Now what?  Well, all investors want the same thing.  That thing is a return on their investment.  That is, they want to get more money than they spend on these things.  Enter, the mortgage interest rate!  You can think of the interest rate on your mortgage as the return an investor somewhere is getting for owning your mortgage.  And there you have it!  Your interest rate is really just a financial incentive for an investor to purchase your loan or a bank to give you one in the first place.

 

So, what’s to stop them from raising interest rates to make more money?  The simple answer is, that you are!  As we’ve seen recently, higher interest rates reduce the number of borrowers applying for loans.  After all, you’ve got to be able to actually afford the house payment for the house you want to live in!  Otherwise, you’ll just stay where you are.  Therefore, the consumer incentivizes investors to keep rates as low as possible.  But what about the other direction?  Why not bring rates way down and get more buyers in the market?  Well, that is a bit more tricky!

 

Since we now know that your mortgage is an investment tool for investors to get a return on their money, we have to look at things through their eyes.  One of the biggest factors in determining where to invest your hard-earned money is the amount of risk a particular investment may carry.  All investments are generally viewed on a risk-reward scale.  The more risk an investment carries, the higher the reward, and vice versa.  In general, mortgages are viewed as very low-risk investments.  Some consider them the second lowest-risk investment out there because people usually prioritize their mortgage payments over all other monthly payments.  What’s the lowest-risk investment then?  The answer is the 10-year treasury note (T-Bills).  This is a bond issued by the government of the United States, which has never defaulted on a payment.  In fact, if they ever did default we would probably have much bigger issues than some investment money (in my opinion).

 

The relationship between the 10-year treasury yield and 30-year mortgage rates is best explained using a graph.  Below, you can see that they tend to trend together.  Historically, the 30-year mortgage rate sits around 1.75% higher than the treasury yield.  

 

 

The reason for this correlation is that investors looking at investing in MBSs will compare them to investing in the 10-year treasury.  Both of these are considered low risk and therefore only generate low returns when compared to other investment vehicles.  Because it is possible for homeowners to default on their mortgage payments, MBSs are considered just slightly more risky than T-Bills.  Therefore, to incentivize investors to buy MBSs, banks need to offer a higher interest rate than what an investor can get with a treasury.  Hence the reason banks can’t offer crazy low rates to get more borrowers.  Investors would simply buy more T-Bills instead and leave the bank holding its mortgage making and very little profit!

 

Now, stay with me because we are about to make it a little confusing.  For a moment, let’s forget about mortgages and just stick with T-Bills.  T-Bills are sold by the US government to fund the many, many programs under its purview.  Think of them as IOUs from the government.  You buy a $100 10-year T-Bill today and then the government pays you back in 10 years plus the interest rate.  Now, believe it or not, the government does have to control the flow of money.  If they sell too many of these bonds, they will owe too much money in the future.  If they don’t sell enough, they can’t meet their immediate financial commitments.  They control this using the bond yield.  If investors begin to flock to the safety of the 10-year T-Bill, the government will offer a lower rate so they don’t overcommit themselves.  Likewise, if not enough investors are buying them, the government will increase rates to incentivize investors to do so.  Clear as mud?  You could say that the demand for those low-risk 10-year T-Bills is what indirectly drives 30-year mortgage rates.  

 

Alright, let’s attempt to tie all this together.  If investors begin buying up all the treasury bonds, the government will lower the offered rates.  This will then cause investors to look for other low-risk investments like MBSs where they can maximize their returns.  On the opposite side of the coin, banks see the lowering yield on the bonds as reduced competition for their product (the MBS) as more and more investors stop buying bonds.  They take advantage of this by lowering interest rates on their mortgage offerings.  In turn, this brings in more borrowers as they can now afford the house they want.  Lots and lots of cause and effect at play here.

 

Now, many more factors go into determining your mortgage rate.  Things like Federal Reserve policies and other broad economic factors come into play, but the relationship to the 10-year treasury is the biggest factor.  Individually, your rate is determined by how “at-risk” you are of missing a payment.  The more risky you are as a borrower, the higher your rate will be to offset that risk for an investor buying your mortgage (here’s that risk-reward thing again!).


In conclusion, this is a complicated subject best understood by nerds like me who love to dig into the “why” of things.  I’ve wanted to write this article for a long time, but have always chickened out due to the complexity of the topic.  Hopefully, this article has made it a little easier to understand and maybe even given you a little appreciation for the complexities at play in our economy.  As always, feel free to contact us if you have any questions or want to discuss this further.  You can also leave us a comment with your thoughts!

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Billy Daniel

After investing in real estate for several years, I decided to get my real estate license so that I could more directly help others navigate the exciting, and sometimes frustrating, world of real esta....

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