How are mortgage rates determined?

Contrary to what many people assume, the bank or lending institution that grants you a home loan doesn't usually hold on to it. Instead, it enters what's called the secondary mortgage market:

These final investors buy tranches to receive a return on investment, which they get from homeowners' mortgage payments. With this system, you can see how the lender and aggregator are middlemen who try to balance interests of the homebuyer and investor. The lower the mortgage rate, the more attractive it is to a homebuyer. The higher the mortgage rate, the more attractive it is to the investor. And both sides are competitive: The homebuyer shops around for the lowest interest rate, while the investor compares the return against other investments.

In this way, the secondary mortgage market determines mortgage rates. But there are still many answers to our original question. In one sense, the price at which the aggregator is willing to buy the loan from the lender determines the mortgage rate. But that price is based on the price at which the tranches of mortgage-backed securities are sold. And, because the price of tranches depends on how much investors are willing to pay for them, investors largely determine mortgage rates.

So, if investors help determine mortgage rates by deciding how much they are willing to pay to invest in mortgage-backed securities, we could ask what goes into such decisions. And that's exactly what we'll explore next.

Ultimately, several factors, including the rate of inflation, the price of U.S. treasuries and the Federal Reserve, affect mortgage rates. That's because all these things and more affect how much investors are willing to pay to invest in the mortgage-backed securities (MBSs) we discussed on the previous page.

Let's start with inflation, which is the phenomenon where the prices of common goods and services rise across the board. Consistent and moderate inflation is actually a sign of a healthy economy, and should ideally result in a proportional rise in wages for workers as well. For lenders, inflation poses an inherent problem -- it means that the money people borrow now will be worth less when they come to pay it back. If economists predict a rise in inflation, investors will insist on higher mortgage rates to make up for this loss.

Because investors have many choices of where to invest their money, competition among other investments also determines mortgage rates. Like with bonds and other financial instruments, investors often compare MBSs against U.S. treasuries. You might assume a 30-year fixed mortgage would compare to a 30-year treasury. But in reality, borrowers in 30-year fixed mortgages are likely to refinance or move after only 10 years. So investors compare such mortgage investments to 10-year treasuries. (And because U.S. treasuries are safer investments, the return on MSBs must be even higher to attract investors.)

When the Federal Reserve, commonly known as the Fed, adjusts certain interest rates, especially the federal funds rate, this has an indirect effect on mortgage rates as well. The federal funds rate is the interest rate banks use when making overnight loans to other banks (to meet end-of-day requirements). To raise this and make borrowing more expensive effectively lowers the supply of available money, which can help stop a rise in inflation. The reverse is also true: lowering the federal funds rate increases the supply of available money and encourages inflation. (It should be noted that the Fed doesn't directly control the federal funds rate, but rather changes it by selling and purchasing securities. For more, see How Interest Rates Work.) As you can probably guess, such adjustments have such wide ripple effects that they affect mortgage rates as well.

We've just skimmed the surface of a complex system of factors that affect mortgage rates. For more on similar financial topics, explore the links on the next page.