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What Moves the Mortgage Market?

Deciphering Industry Jargon and Identifying Key Drivers

When you're in the market for a mortgage loan, it's never a bad idea to get a better understanding of what affects mortgage rates.  There are scores of economic and even political factors that can influence rates, and single events of high importance, such as Federal Reserve meetings, have the potential to greatly affect rate trends at any given time.  But one of the most important sources of influence lies within the yield of the 10 Year Treasury Note:

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Pictured above is an example of a physical 10 Year Treasury Bond for $5,000. 

The next section will delve into how this bond exerts such enormous influence on US mortgage rates. 

It may not be the most thrilling read, but you'll place yourself miles ahead of the average homebuyer after understanding this information.

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  • 10 Year Treasury Note Yield - 

    • The 10 Year Treasury (10YT) Note is a type of government bond, a type of debt obligation you can purchase from the US government that entitles you to the full face value of the bond upon its maturity date, as well as interest payments at set intervals.    ​

      • For example, a $100 10YT Note will pay out interest payments every 6 months to the holder, and will pay its holder $100 upon maturity, 10 years after purchase (unless purchased from the original buyer after time has already elapsed). 

    • The 10 Year Treasury yield, or the rate of interest the holder is set to receive, is one of the most important figures in national and global finance.  Along with other government bonds, it is considered the safest investment in the US, and among the safest investments globally, as each bond is backed by the full faith and credit of the US government, which has never defaulted on debt in its history.  Countless other rates of return are based upon the 10YT yield, mortgage interest rates included.  Now why would that be?

    • The same investors who buy government bonds by the thousands, also invest in other securities, such as stocks, stock options, or, let's say, mortgages.  How on earth does one invest in a mortgage?  Typically, after lenders fund a loan, they would much rather restore the gap in their pockets left by your mortgage loan, rather than holding onto your mortgage debt and collecting the interest payments you make over the next 15 or 30 years. 

    • By restoring their missing funds, they can start lending to more people, so they take your mortgage and sell it to investors.  Often times, mortgages are bundled together by the hundreds or thousands and sold to investors as what the industry calls a "mortgage-backed security" (MBS).  You get your house, investors collect your mortgage payments with your interest rate providing solid returns, and the lender gets their money back to begin issuing more mortgage loans, everyone wins.  The financial space in which these transactions occur is known as the "secondary market".

    • Let's say, however, that the 10YT yield starts shooting upward, providing investors with higher returns on an extremely safe investment.  And lets compare the safety of that investment to mortgages: among the thousands of loans contained in a mortgage-backed security, it is likely that a significant number of those mortgages will either be:

      • Paid off early through a sale of home or refinance, depriving the investor of the expected prolonged returns, OR

      • Go into default if the homeowner no longer makes their payments.  

    • If the rate of return on a virtually risk-free investment like the 10YT note goes up, it is only natural that, for riskier investments such as mortgage-backed securities, investors will demand a similar increase in rates to justify the increase in risk compared to government bonds.  Though there are other impacts the 10YT note imparts upon the financial world, the rise and fall of its yield is typically the most reliable indicator of the mortgage rate environment.  â€‹â€‹

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  • Applause to you if you have gotten this far.  Wouldn't blame you for zoning out when it comes to dissecting the relationship of government bonds on mortgage rates.  But how does inflation factor into this?  After all, in 2022, the US is facing record high levels of inflation not seen since the 80s, which is having a considerable negative impact on rates.

    • A similar concept applies to the relationship between government bond yields and mortgage rates.  But before we fully dive in, let's expand on a previously mentioned item, the mortgage backed security (MBS).​

    • The mortgage backed security is, as aforementioned, a financial instrument composed of thousands upon thousands of mortgage loans all bundled up together to produce an investment opportunity for those who would like to collect the mortgage payments and interest of all those homeowners. 

      • These mortgage backed securities are very similar to another financial instrument that you are likely much more familiar with: stocks.  A mortgage backed security will have a market value that fluctuates based on investor demand.  If mortgages are not seen as an attractive investment at the time for whatever reason, MBS values will fall, and investors will stop purchasing them. 

      • If you, the lender or aggregator that creates these mortgage backed securities in the hopes of selling them to replenish your lending funds, see a precipitous drop in the demand of your MBS, what do you think you'd do to make your MBS more appealing?  Raise.  Rates.  

      • By raising the mortgage rates a lender offers, the resulting MBS that is created will present a greater rate of return for a potential investor, once again attracting attention back to the MBS and allowing lenders across the country to resume operations.  It may seem like this supply and demand serves only to hurt the borrowers.  In reality, without the MBS system, the availability of a mortgage loan itself would shrink drastically and likely reduce competition between lenders so severely that the few remaining entities could gouge the public.

    • So where does inflation fit into all of this?  If you guessed that a high rate of inflation reduces the attractiveness of any investment with a rate of return that is lower than the inflation rate, you guessed correctly.  

      • Consider that the average rate of inflation in the US in the year 2019 was 1.81%.  Now compare that to a 40-year high in July of 2022 at a staggering 9.1%.  ​Any investor would balk at such a disparity, and would subsequently not settle for any investment that presents too wide of a gap between the rate of inflation.  This would trigger the chain of events mentioned earlier, with lenders subsequently raising interest rates to maintain the appeal of their securities.

      • You may be thinking, "But Ryan, isn't a 10 Year Treasury Bond yielding something like 3.3% right now?".  And that is an excellent point.  But consider that a government bond is backed by the full faith and credit of the US government, making it a virtually 0% risk investment, whereas among the thousands of mortgages bundled into an investment like an MBS, your risk of defaults or refinances presents a significant downside to your future rate of return.  Even with such a large disparity between inflation and a bond yield, investors recognize that a 100% safe investment is a powerful tool to weather economic turbulence.  Mortgage backed securities?  Not so much, unless the rate of return justifies the significantly increased risk.

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In the end, much of the factors powering mortgage rate fluctuations are tied to the risk appetites of the investors that help supply the American populace with the liquidity for mortgage lending to be widely accessible.  Now you have an elevated understanding of a facet of the American securities market.  Use this incredible power responsibly.

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