How are mortgage rates determined?

Follow the Money: The Secondary Mortgage Market

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:

  1. The bank/lender sells your mortgage to a large, third party investor -- typically a mutual fund or an institutional investor -- known as an aggregator.
  2. That aggregator packages together your loan with many other loans into what's called a mortgage-backed security (MBS).
  3. It then divides that mortgage-backed security into shares known as tranches to sell to other investors.

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.