Bond rates directly affect mortgage rates. This may seem a bit strange, but there are logical reasons for this effect. Most mortgage loans are sold into the secondary market. The secondary market then sells "pools" -- groups -- of mortgages or creates mortgage-backed securities into the investment market. Their competition is bonds -- longer term investments with specified returns -- interest rates. This causes bond rates and prices to directly affect mortgage rates.
Bonds, whether corporate or municipal -- issued by local governments -- tax free or not, are long-term investment choices favored by large institutional, insurance, pension plan or other government investors. They offer a stated interest rate of return and are less volatile than common stocks. The risk versus reward factor is lower, but these investments are historically much safer that common stocks.
Groups of mortgages can be "pooled" to create a larger investment product favored by institutional buyers -- insurance companies, pension plans or local governments. Like bonds, mortgage pools are less volatile and much more secure than common stocks. Similar investors must concentrate on safety more than profit possibilities. Mortgage pools are safer than any common stock investments.
Similar to mortgage pools, mortgage-backed securities (MBS) compete directly with bonds in the investment market. The difference from mortgage pools: The investor owns the security, backed by mortgages, instead of the mortgages themselves. For example, a bond with a stipulated earnings rate of six percent will compete with a mortgage backed security of six and one-half percent. If the mortgages backing up the security are sound, the security is a better option.
Mortgage Rate Effects
Instead of being influenced by the prime rate or auto loans, mortgage rates are more heavily influenced by the bond market. When the bond market is strong, with many investors, the mortgage rate tends to decrease. Conversely, when the bond market is weak, mortgage interest rates tend to increase, to make pools or securities more attractive to investors. This influence renders other consumer interest rates --auto, personal, home equity -- less important to affecting published mortgage rates.