Personal Finance: Mortgage rates headed back up

The cost of buying a home rose again last week as mortgage rates continued their ascent. The national average rate for a 30-year fixed rate mortgage crossed the 7% mark, up from around 6% in February. That differential would add about $165 to the monthly payment on a $250,000 loan and is a major factor contributing to the affordability crisis in housing, especially for first-time homebuyers.

Ongoing concern over sticky inflation, the stalemate in the Middle East and a ballooning federal debt are all contributors to the upward march. But have you ever wondered how mortgage rates are determined and why they fluctuate daily? The answer lies in the unique mechanism by which homes are financed in America involving a pair of quasi-governmental agencies known by the nicknames of Fannie Mae and Freddie Mac that nearly blew up the world in 2006.

Even though a homebuyer may secure a mortgage loan from their local bank or credit union, these financial institutions generally continue to hold only a fraction. Frank Capra’s version of a building and loan in “It’s a Wonderful Life” is a relic of a bygone era. Today, 70% of conventional loans originated by financial institutions are typically sold to government-sponsored entities, freeing up capital for the bank to lend out to businesses and consumers. The loans are then bundled up by these GSEs into securities that can be sold to individual investors seeking an income stream. It is through the massive market for these so-called mortgage-backed securities, or MBS, that your individual rate on a home loan is determined.

The first of these government-sponsored entities was the Federal National Mortgage Association. Created by Congress in 1938, it quickly acquired the moniker “Fannie Mae” from its acronym FNMA. Its purpose was to provide liquidity to the mortgage market, holding down interest rates and enabling more average families to purchase a home. As Fannie Mae grew into an enormous monopoly, Congress created the Federal Home Loan Mortgage Corporation in 1970. It soon gained the nickname “Freddie Mac.”

Although both Fannie and Freddie are technically shareholder-owned corporations, they rely heavily upon an implicit government guarantee since their failure would devastate the market for single family mortgages. That backstop was tested during the great financial crisis of 2006-2008, during which mismanagement and lax lending standards led to a nearly catastrophic failure and ultimate taxpayer rescue.

The agencies remain under government conservatorship today awaiting a plan for re-privatization which never seems to happen. However, significant reforms were implemented in the aftermath of the crisis, and the market has remained relatively stable.

So how does all of this impact the rate you are likely to get on a new 30-year mortgage?

Since the bank making the loan is likely not planning to keep it, its mortgage rate is determined by the price Fannie and Freddie are willing to pay for the loans to repackage into mortgage-backed securities. That price is in turn dependent on the current interest rate on U.S. Treasury bonds, specifically the 10-year treasury note.

Here’s how it works.

Investors can earn what is considered a relatively risk-free return by purchasing U.S. treasury bonds.

Currently, a 10-year treasury has an annual yield of about 4.9% and is backed by the full faith and credit of the United States. Investors can, however, seek a higher return by taking on additional risk in purchasing mortgage-backed securities (MBS). Recall that these are bundles of individual home loans packaged together and sliced up into smaller shares that are available for the public to purchase. Owners of these MBS securities receive the flows of interest and principal that are collected from all the single mortgages in the pool.

Unlike a treasury bond however, which has a fixed maturity, holders of MBS are subject to early repayments when a homeowner decides to refinance or pay off their mortgage early. This prepayment risk may mean the MBS holder has to reinvest the proceeds at a lower interest rate. Holders are also subject to potential defaults through foreclosures, generally a small but non-zero fraction of the pool. To assume this additional risk, MBS buyers demand a higher return, known as the secondary “spread” or premium in this secondary mortgage market over the risk-free 10-year rate. The current secondary spread is around 0.75%, giving MBS investors a yield of around 5.65% versus 4.90% on the treasury note in exchange for the prepayment and credit risk.

Enter the banks and other originators that write your mortgage loan. This is called the primary market where loans are created, contrasted with the secondary market where they are resold to Fannie and Freddie. The bank must also add its own spread to cover various costs of underwriting, administration, servicing the loan and its profit margin. This additional premium is called the “primary-secondary” spread and, as of this writing, sits at around 1.35%.

All this to say that the average 7% 30-year mortgage rate is determined in the marketplace by stacking additional spreads or extra compensation on top of the current rate on the risk-free U.S. treasury bond. This rate is dynamic, shifting daily with changes in treasury yields, borrower demand and investor risk appetite. Contrast the current rate with the historically low 2.65% 30-year mortgages in 2021 and it is easy to understand why homeownership has slipped beyond the grasp of many families.

In addition to equilibrium rates determined in the MBS market, there are also borrower-specific factors that can impact an individual’s particular rate. Weaker FICO credit scores can add nearly 1 percentage point to the rate for a highly qualified borrower. Also, the loan amount versus the down payment or loan to value ratio is determinative, and some lenders offer lower rates in exchange for up-front fees or “points.” Getting the best rate starts with checking and potentially repairing your credit record, shopping around with several lenders and being realistic about what you can afford. Happy hunting.

Christopher A. Hopkins, CFA, is a co-founder of Apogee Wealth Partners in Chattanooga.