One challenge when shopping for a mortgage is deciding whether to lock in the current rate or wait to see if interest rates drop. While it is not an exact science, keeping an eye on certain Treasury security rates will give you a good indication of potential changes in mortgage rates. Mortgage lenders price new loans based on market rates, where Treasury rates are the primary benchmarks.
10-Year Treasury Benchmark
Of the range of Treasury security terms that go from 13 weeks to 30 years, the 10-year Treasury rate is widely accepted as the benchmark rate for 30-year mortgage rates. While it seems that the 30-year mortgage rate should be based on the 30-year Treasury, the effective term of a 30-year mortgage, or mortgage-backed security, averages seven to 10 years. With a mortgage, a portion of principal is paid off each month, and homeowners often sell or refinance to pay off home loans early. As a result, mortgage lenders base much of their rate-setting decisions on what is happening with the 10-year Treasury rate.
Historical Rate Spread
Mortgage lenders use the Treasury rate as a guide and not as an absolute basis for home loan rates. The historical rate spread between the 10-year Treasury and 30-year mortgages spent most of the time between 1.5 and 2 percent. However, mortgage rates have been as high as 3 percent more than the Treasury rate, and the spread has narrowed to as little as 1 percent. In the shorter term, you watch the Treasury to see if rates are rising or falling, because the current spread will not change over the short term.
If your new mortgage conforms to the guidelines of either the Federal Housing Administration, the Veterans Administration, Fannie Mae or Freddie Mac, your new home loan will be packaged together with many similar loans and that "pool" of mortgages will be sliced up and sold to investors in the bond markets. Mortgage-backed securities have implicit government guarantees, and these bonds compete with Treasury securities for investor dollars. The packaging of new home loans into mortgage-backed securities is the reason why mortgage rates are uniform across the country and closely tied to Treasury security rates.
Adjustable Rate Mortgages
The rate for an adjustable rate mortgage, or ARM, may be linked to a different part of the Treasury security spectrum. The rate on an ARM will be calculated using an index rate plus a spread. The one-year Treasury rate is commonly used as an ARM index rate. With ARM loans, the initial rate may have little to do with the Treasury rate and will be set as a "teaser" rate to attract business. Once an adjustable loan starts to adjust, if the Treasury is the index rate, the ARM rate will be directly tied to changing rates in the Treasury market.
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