As you weigh the pros and cons of buying or refinancing your home, you probably keep a careful eye on the ever-changing mortgage rates and wonder what causes the rates to rise and fall. Many people do not realize that the rate you pay on your mortgage has a lot to do with the creditworthiness of the United States government.
Lenders would pretty quickly run out of cash if mortgages were kept in bank lending portfolios. The majority of these debts are sold to investment firms, which in turn sell partial ownership of the loans to investors in the form of mortgage-backed securities. The investors who buy these bonds receive your interest payments and get an eventual return of principal when you finish paying off the loan. Exchanges around the world sell mortgage-backed securities as well as other debt instruments, known as bonds, that are issued by corporations and governments. These entities need to raise cash to cover short-term expenses and investors can choose between buying these bonds or buying your mortgage.
When you apply for a 30-year mortgage, the lender might require you to pay a slightly higher rate than your friends or neighbors if you have a low credit score. People with low scores are seen as risky borrowers. Lenders mitigate that risk by charging these borrowers higher rates. The same principal applies to corporations, municipalities and even national governments. Most investors view federal bonds as the lowest risk debt instruments because the federal government can raise revenue by taxing a few hundred million Americans if it ever runs short of cash. In contrast, you are a high risk borrower because if you lose your job you cannot raise funds by imposing a new tax on the American public.
Most homeowners payoff their 30-year mortgages within 10 years as a result of refinancing or selling their homes. Consequently, investors compare 30-year mortgages with 10-year federal treasury bills rather than 30-year federal debts. As low risk instruments, the rates on 10-year treasuries are usually lower than rates on other debt securities. Investment analysts use the word "spread" to describe the price gap between the going rate on treasuries and 30-year mortgages. The spread typically fluctuates between about 1 percent and 3 percent. Whenever treasury rates rise, mortgage rates rise.
During economic booms, investors are drawn to high risk instruments such as stocks since these have more growth potential than bonds. Therefore, the federal government has to raise rates on bonds to attract investors. This in turn drives up mortgage rates. During periods of recession the opposite occurs because investors tend to park their money in low risk vessels such as bonds. This means governments can borrow money more cheaply. This in turn drives down the average rate being charged by lenders for mortgages.