How Are Mortgage Rates Determined?

Mortgage rates and pricing are set by a number of economic factors.  Mortgage rates are primarily influenced by the performance, supply and demand of the US bond markets.  Other major contributing factors in determining mortgage rates are the US and global stock markets, their daily performance as well as current events in the US and abroad to name a few.

How Bonds Effect Mortgage Rates

What is a bond?  Bonds are a form of debt.  Bonds are loans, or IOUs, funded by individuals and/or institutional investors.  Investors loan money to a company, city or the government on a commitment to pay back in full with regular interest payments.  The interest paid on a bond is referred to as the yield.  A city may sell bonds to raise money to build a bridge, while the federal government issues bonds to finance mortgages and many other economic events.

In the US and many other countries, individual mortgages are bundled together, packaged as securities and sold in chunks as mortgage bonds. 

Bond markets move up and down daily just as stock markets do.  A rally in the stock market signals investors that stock market returns are on the rise.  This will pull funds away from the safe haven of the bond markets into stocks/equities.  In turn, the supply of investors purchasing bonds decreases. When this occurs the price of a prospective bond drops and the yield paid to the prospective bond purchaser increases to entice investors back into bonds.  When demand shifts back to bonds this will cause bond yields rise and mortgage rates to rise as well.  Why is this, you ask? Read on!

Another sometimes confusing factor in mortgage pricing is the relationship between the price of bonds and the effect bond prices have on interest rates.  When bond prices go up it indicates stronger demand for bonds or more available supply.  Increased supply causes the yield or return on investment paid by the bond issuer to fall.  This trend will often be signaled by investors pulling money out of the stock/equity markets and re-investing that money back into bonds as a flight to safety.  Nervous investors often flock to the safety of bonds and the steady stream of income they generate when the stock market becomes too volatile.  Major world events such as economic downturns, natural disasters and tensions between countries signaling conflict can worry investors and cause volatility in the stock markets.  In turn, investors worry these events will cause the stock markets to fall, putting their investments at risk. 

When the supply of available investor money to bond issuers is plenty, the bond issuer can charge a premium to the bond holder and the interest to be paid to the bond holder/investor goes down.  Since mortgages are essentially a type of bond, when the price of bonds begins to rise, the return on investment goes down. This causes the bond issuer to charge a higher rate of interest to the individual mortgage borrowers that make up the mortgage backed security (mortgage bond).  The increase in rates must occur to maintain the target profit margin to pay interest/yield promised to the investors funding the bond.

This principal causes the inverse relationship between bond prices and mortgage rates.