The rates for mortgage loans will usually run in parallel to certain rates in the bond market. This is the result of how mortgages are funded and packaged for sale to investors. Investors buying mortgage-backed securities look for rates that are competitive with other fixed income investment options such as Treasury and corporate bonds.
The majority of new mortgages are purchased from lenders and combined into pools of loans with similar rates and terms. The mortgage pools are then divided up and sold to investors as mortgage-backed securities -- MBS. The investors in a mortgage security receive payments on their investment as the homeowners in the with loans in the pool make their monthly house payments.
The largest proportion of mortgage-backed securities are comprised of mortgage loans guaranteed by an agency or sponsored entity of the U.S. government. These companies are Ginnie Mae, Fannie Mae and Freddie Mac. The mortgage-backed securities from these companies are identified by the same names. Mortgage securities from Fannie, Freddie and Ginnie Mae have implicit or implied government backing, making them some of the safest fixed income investments.
A pool of 30-year mortgages will have an effective duration for investors of seven to eight years. The high quality of government backed MBS and this duration puts them in competition with U.S. Treasury five- to 10-year bonds. Treasury securities are considered the safest income investments. Mortgage securities with government backing have a similar level of safety, so mortgage-backed securities will be priced to yield just above the comparable Treasury bonds.
The U.S. Treasury market is the largest and most liquid bond market. The current interest rate paid by Treasury securities are used as the benchmark for other types of debt securities. The mortgage-backed securities market is closely tied to the Treasury bond market due to the similarities in safety and maturity. As rates on Treasury bonds change, the rate for mortgage loans will change to maintain the rate differential between mortgage rates and U.S. government bond rates.
The rate homeowners in a mortgage pool are paying is not the rate an MBS investor in that pool will earn. Mortgage loans have servicing companies that take a portion of the interest paid by the homeowners. The mortgage lenders may also put profit into the rate of a mortgage, reducing the rate to the mortgage pool. The result is that mortgage rates typically stay in a range of 1.5 to 2 percent above the current rate for the 10-year Treasury bond. As the rate on the 10-year Treasury changes, the rates lenders are charging for new mortgage loans will also change to maintain this spread.
Tim Plaehn has been writing financial, investment and trading articles and blogs since 2007. His work has appeared online at Seeking Alpha, Marketwatch.com and various other websites. Plaehn has a bachelor's degree in mathematics from the U.S. Air Force Academy.