How Interest Rates Affect the Housing Market

1

• How Interest Rates Affect the Housing Market

2

• Mortgages come in two primary forms fixed rate
  and adjustable rate with some hybrid
  combinations and multiple derivatives of each. A
  basic understanding of interest rates and the
  economic influences that determine the future
  course of interest rates can help consumers make
  financially sound mortgage decisions, such as
  making the choice between a fixed-rate mortgage
  or adjustable-rate mortgage (ARM) or deciding
  whether to refinance out of an adjustable-rate
  mortgage.
• In this article, we'll discuss the influence of
  interest rates on the mortgage industry, and how
  both will ultimately affect the amount you pay
  for your home.
• The Mortgage Production Line
• The mortgage industry has three primary parts or
  businesses the mortgage originator, the
  aggregator and the investor.

3

• The mortgage originator is the lender. Lenders
  come in several forms, from credit unions and
  banks to mortgage brokers. Mortgage originators
  introduce and market loans to consumers. They
  sell loans. They compete with each other based on
  the interest rates, fees and service levels that
  they offer to consumers. The interest rates and
  fees they charge consumers determine their profit
  margins. Most mortgage originators do not
  "portfolio" loans (meaning that they do not
  retain the loan asset). Instead, they sell the
  mortgage into the secondary mortgage market. The
  interest rates that they charge consumers are
  determined by their profit margins and the price
  at which they can sell the mortgage into the
  secondary mortgage market.

4

• The aggregator buys newly originated mortgages
  from other institutions. They are part of the
  secondary mortgage market. Most aggregators are
  also mortgage originators. Aggregators pool many
  similar mortgages together to form
  mortgage-backed securities (MBS) a process
  known as securitization. A mortgage-backed
  security is a bond backed by an underlying pool
  of mortgages. Mortgage-backed securities are sold
  to investors. The price at which mortgage-backed
  securities can be sold to investors determines
  the price that aggregators will pay for newly
  originated mortgages from other lenders and the
  interest rates that they offer to consumers for
  their own mortgage originations.
• There are many investors in mortgage-backed
  securities pension funds, mutual funds, banks,
  hedge funds, foreign governments, insurance
  companies, and Freddie Mac and Fannie Mae
  (government-sponsored enterprises).

5

• Since investors try to maximize returns, they
  frequently run relative value analyses between
  mortgage-backed securities and other fixed income
  investments such as corporate bonds. As with all
  financial securities, investor demand for
  mortgage-backed securities determines the price
  they will pay for these securities.
• Do Investors Determine Mortgage Rates?
• To a large degree, mortgage-backed security
  investors determine mortgage rates offered to
  consumers. As explained above, the mortgage
  production line ends in the form of a
  mortgage-backed security purchased by an
  investor. The free market determines the market
  clearing prices investors will pay for
  mortgage-backed securities. These prices feed
  back through the mortgage industry to determine
  the interest rates offered to consumers.
• Fixed Interest Rate Mortgages
• The House Loan Interest on a fixed-rate mortgage
  is fixed for the life of the mortgage. However,
  on average, 30-year fixed-rate mortgages have a
  lifespan of only about seven years. This is
  because homeowners frequently move or will
  refinance their mortgages.

6

• Mortgage-backed security prices are highly
  correlated with the prices of U.S. Treasury
  bonds. This means the price of a mortgage-backed
  security backed by 30-year mortgages will move
  with the price of the U.S. Treasury five-year
  note or the U.S. Treasury 10-year bond based on a
  financial principal known as duration. In
  practice, a 30-year mortgage's duration is closer
  to the five-year note, but the market tends to
  use the 10-year bond as a benchmark. This also
  means that the interest rate on 30-year
  fixed-rate mortgages offered to consumers should
  move up or down with the yield of the U.S.
  Treasury 10-year bond. A bond's yield is a
  function of its coupon rate and price.
• Economic expectations determine the price and
  yield of U.S. Treasury bonds. A bond's worst
  enemy is inflation. Inflation erodes the value of
  future bond payments both coupon payments and
  the repayment of principle. Therefore, when
  inflation is high, or expected to rise, bond
  prices fall, which means their yields rise
  there is an inverse relationship between a bond's
  price and its yield.

7

• The Fed's Role
• The Federal Reserve plays a large role in
  inflation expectations. This is because the bond
  market's perception of how well the Federal
  Reserve is controlling inflation through the
  administration of short-term interest rates
  determines longer-term interest rates, such as
  the yield of the U.S. Treasury 10-year bond. In
  other words, the Federal Reserve sets current
  short-term interest rates, which the market
  interprets to determine long-term interest rates
  such as the yield on the U.S. Treasury 10-year
  bond.
• Remember, the interest rates on 30-year mortgages
  are highly correlated with the yield of the U.S.
  Treasury 10-year bond. If you're trying to
  forecast what 30-year fixed-rate mortgage
  interest rates and House Loan Interest will do in
  the future, watch and understand the yield on the
  U.S. Treasury 10-year bond (or the five-year
  note), and follow what the market is saying about
  Federal Reserve monetary policy.

8

• Adjustable-Rate Mortgages
• The interest rate on an adjustable rate mortgage
  might change monthly, every six months or
  annually, depending on the terms of the mortgage.
  The interest rate consists of an index value plus
  a margin. This is known as the fully indexed
  interest rate. It is usually rounded to
  one-eighth of a percentage point. The index value
  is variable, while the margin is fixed for the
  life of the mortgage. For example, if the current
  index value is 6.83 and the margin is 3,
  rounding to the nearest eighth of a percentage
  point would make the fully indexed interest rate
  9.83. If the index dropped to 6.1, the fully
  indexed interest rate would be 9.1.
• The interest rate on an adjustable-rate mortgage
  is tied to an index. There are several different
  mortgage indexes used for different
  adjustable-rate mortgages, each of which is
  constructed using the interest rates on either a
  type of actively traded financial security, a
  type of bank loan or a type of bank deposit. All
  of the different mortgage indexes are broadly
  correlated with each other.

9

• Forecasting Changes
• If you're trying to forecast interest rate
  changes on adjustable-rate mortgages, look at the
  shape of the yield curve. The yield curve
  represents the yields on U.S. Treasury bonds with
  maturities from three months to 30 years.
• When the shape of the curve is flat or downward
  sloping, it means that the market expects the
  Federal Reserve to keep short-term interest rates
  steady or move them lower. When the shape of the
  curve is upward sloping, the market expects the
  Federal Reserve to move short-term interest rates
  higher.
• The steepness of the curve in either direction is
  an indication of by how much the market expects
  the Federal Reserve to raise or lower short-term
  interest rates. The price of Fed Funds futures is
  also an indication of market expectations for
  future short-term interest rates.

10

• The Bottom Line
• An understanding of what influences current and
  future fixed- and adjustable-rate mortgage rates
  can help you make financially sound mortgage
  decisions. This knowledge can help you make a
  decision about choosing an adjustable-rate
  mortgage over a fixed-rate mortgage and can help
  you decide when it makes sense to refinance out
  of an adjustable rate mortgage. Below are a few
  final tips.
• Source investopedia.com/articles/pf/07/mortgage
  _rate.asp