What Are Mortgage Loan Interest Rates Based Upon?

Mortgage interest rates are based on bond market rates and competition.
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Prospective homebuyers are often mystified by mortgage interest rates. As credit card rates escalate to high levels or personal loan rates hover around 10 percent, people see mortgage rates around 5 percent. Learning how mortgage rates are influenced and calculated helps people understand the market and become more informed real estate consumers. While you may not become an interest rate prediction "guru" broadcasting cable TV infomercials from your yacht at 1:00 a.m., you can make better home-financing decisions.

Not Consumer Loans

While you could argue that home mortgages rank as the ultimate consumer loan, their rates usually aren't based on loans at all, but instead on a combination of savings rates, general market conditions, and competition. Banks and credit unions, should they want to increase their loan volume, must base rates of consumer loans -- personal, auto, credit card and home equity -- on their cost of funds (savings rates) and their competition's rates. Mortgage rates seldom factor into the comparison.

Bond Market Influences

The bond market serves as the primary base for mortgage rates. As most lenders sell all mortgages into the secondary market and most secondary market buyers package their loans into securities, they directly compete with bond sellers. They're actually quite similar: long-term investments with stated rates of return (interest rates), secured with strong collateral and offer structured payments of interest or, with mortgage securities, principal and interest. Because of this competition, the bond market directly influences published mortgage rates.

Competitive Influences

The creation of the secondary market in 1971 -- the birth of Fannie Mae (Federal National Mortgage Association) -- changed the mortgage lending landscape forever. Prospective homeowners enjoyed consistent and low-cost availability of mortgage funds, and continue to reap these fruits. Lenders wanting to increase their volume of mortgage loans will "shave" secondary market interest rates as much as possible to get an edge over their competition. However, the basis, the rates published by Fannie and Freddie, can only be modified conservatively as the "market makers."

Basis Variations with ARMs

Adjustable-rate mortgages, while influenced by published fixed rates -- as their primary competition -- are based on U.S. Treasury Securities and other similar short-term indexes. However, ARM lenders can offer start rate discounts to attract borrowers. For example, a one-year ARM with a full market rate of 5 percent may be offered at 4.25 percent. Helping many more borrowers qualify -- thereby increasing loan volume -- lenders offering discounts only risk below market rates for one year, not 30. After year one, these loans can be priced to market -- fully indexed to their true rate -- generating appropriate income to the lender.

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