Mortgage Interest Rates

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Basics

A mortgage is categorized under debt instruments. The main characteristic of mortgage is that it is secured by the collateral of specific real estate property. In case of default in repayment the lender will have rights in the specific collateral as stated in the mortgage clause. Mortgages help to make large value purchases without having to pay the whole amount upfront. It is also known as liens against property, or claims on property.

Dynamics

The driving factors of mortgage rates are somewhat obscure to the layman. In fact it is the investors in the secondary market who drive the rates.

The originator or the lender may be a financial institution. When the funding happens the money flows from the Originator to the borrower onto the person who sold the home.

At this juncture the originator can either keep the loan in portfolio or enter the secondary market to sell it. If the loan is in the portfolio then the Originator gets his interest payments every period. Otherwise Originator replenishes own funds by selling it in the secondary market as mortgage backed securities (pass through) and with the replenished funds more such mortgage funding can be made. Thus the funds keep circulating due to the secondary market.

Any financial institution and even government backed institutions like Fannie Mae and Freddie Mac, insurance companies, securities dealers, and pension funds are prominent players in the secondary market. These types of investments can easily be encashed.

The expected level of return depends upon the current and future expected economic condition. In a booming economy future yields will be higher. Investors will stop buying until then. Thus mortgage interest rates go up, because lenders hesitate to sell their loans at the prevailing lower yields.

Alternatively, in a downturn, investors will buy more because of apprehension that the yields will fall later and driving the rates down.

Analysis

In September The Fed has continued the trend of cutting key short-term interest rates by dropping the federal funds rate by 1/2 percent.

The discount rate has also been reduced by a 1/2 percent in August. There is a popular expectation of further rate cuts in the near future.

This rate cut by Fed is to release more funds by making them cheaper for lending institutions so that it can be transferred into the economy through lending. This is done to boost investment and mitigate the risk of recessionary damage.

In case of the mortgage market, these rate cuts impacts the floating rate mortgages most as these rates are tied to a benchmark rate which gets readjusted. However this is not be ideal for long term rates, especially fixed ones. This is evident from the fact that long term 30 year fixed rate loans jumped by around 1/8th percent when the short term rates were lowered recently. This is because in fixed rate mortgages the lender and investor is locked in a fixed return for long period and hence these rates mainly fluctuate based on the perception of future rates of inflation.

The Fed has taken notice of the potential economic slowdown and has started taking actions hence fixed rate mortgages can be expected to remain fairly stable. Actually it is the economic forecast that will be the key determinant. However there can be no one to guarantee economic or interest rate predictions.

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