Mortgage

How Does the Mortgage Market Work?

If you’re in the market to purchase or refinance a home,you’re probably being exposed to a whole range of information the average person doesn’t think about on a routine basis. You’re looking at mortgage rates, but how are they set anyway? What is it exactly that mortgage investors like Fannie Mae, Freddie Mac and the VA do? Finally, after your loan closes, what the heck is mortgage servicing?

That’s a lot to cover, but we’ll break things down. Let’s jump in with a look at mortgage rates.

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How Are Mortgage Rates Determined?

When shopping around for mortgage rates, there’s probably a temptation to think lenders set these things pretty arbitrarily. However, there are actually two big facets to determining the interest rate on a mortgage: market conditions and your personal financial profile.

How Base Interest Rates Are Set in the Market

There are a few different market factors that affect interest rates for mortgages. In addition to the day-to-day activities of mortgage bond traders, the Federal Reserve also plays a role. Let’s dig into that first.

The Role of the Federal Reserve

In its original mandate from Congress, the Federal Reserve was set up to be the central bank of the United States. This means it has a variety of responsibilities, including overseeing banks as a whole and setting certain financial policy regulations. But perhaps the most important role it plays from a consumer perspective is in the setting of short-term interest rates.

When the Fed’s Open Market Committee (FOMC) meets to determine what this benchmark interest rate should be at any given time, they have a couple of key goals:

The Fed has a bit of a balancing act here because those goals sometimes run in competition with each other. To achieve the highest possible rate of employment, you might choose to keep interest rates low, because cheaper borrowing can stimulate businesses to invest. This can lead to more hiring as well as more money spent on goods and services, which can have a knock-on effect and help still more businesses prosper.

However, if the cost of borrowing funds is too low, this also tends to mean that the money you have saved in the past is worth less than if higher borrowing costs made funds scarcer. If your money isn’t worth as much, prices can go up quickly, as you need to part with more money to get the same amount. Pretty soon you end up paying $15 for a loaf of bread.

It should be noted that a little bit of inflation can be a good thing, since the threat of rising prices can encourage people to buy now rather than wait for some undetermined date in the future, stimulating economic activity. But it’s important for the Fed to keep a thumb on the scale. Recently, the target goal has been 2% inflation per year.

The Fed must do its best to maintain an equilibrium between these two factors when it sets the benchmark short-term interest rate, which is the rate at which federally insured banks can borrow money each night. The range of short-term interest rates currently sits between 2.25-25%.

Although the most immediate impact may be felt in the rates for short-term lending – credit cards, personal and auto loans – longer-term payoffs like mortgages do tend to correlate with these short-term rates. Depending on market factors, which we discuss below, the base interest rate for a mortgage might run between 2% – 3% higher than short-term rates.

Bond Trading and Mortgage Rates

When the practice of lending money for people to buy homes first started, a bank would look at the qualifications of the borrower and, if they made a loan, hold on to it until the loan was paid off, potentially 20 or 30 years down the line.

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While some banks still do this today, the advent of the mortgage-backed security (MBS) has changed things up a bit. Let’s look at a brief overview of how the process works.

After your loan closes, it’s packaged up with other mortgages that have similar characteristics to your loan. As an example, a single MBS might have 100 conventional loans with credit scores above 680 and down payments of between 15% – 20% on primary properties.

The investor – most often an institution, but it could be an individual – has the opportunity to buy this at a rate of return dictated by the market. Those rates of return are what’s important in determining mortgage rates.

The advantage of this system for the mortgage originators whom you previously worked with to close your loan is that they can receive cash from a mortgage investor who backs the bond and packages it as an MBS, giving them the capital to make more loans without having to wait for payments to come in over the full course of the term.

The stock and bond markets have a tendency to operate with a push-pull effect. Stocks are considered riskier because they are fed by corporate earnings results and, more often than not, by speculation on what a company will or won’t do well off into the future. They’re somewhat more speculative, but they can offer a higher rate of return in exchange for the increased risk.

Bonds, on the other hand, could be for anything from local municipal projects to large-scale government operations to mortgage bonds – the last of which are paid into each month when homeowners make their payments. Since the borrowing that underlies bonds tends to be for essential goods and services, this is considered a much safer investment in stocks, because people will pay off the necessities.

This is where the push-pull comes in. When stocks are going up and people are feeling good about the state of business and the economy, they pour more money into equities and take it out of bonds. Because MBS are traded on the bond market, mortgage rates tend to rise, as the rate of return on bonds needs to be higher in order to attract investors. On the other hand, if people are uncertain about the future at home or abroad, the money goes back into the safety of the bond market, which can have the effect of lowering mortgage rates.

In addition to setting monetary policy, the Fed has in recent years played a role here as well. As part of an economic stimulus package instituted after the 2008 financial crisis and now being wound down, the Federal Reserve holds more than$1.6 trillion in MBS and has been the market’s largest buyer. The intention was to keep mortgage rates lower while the economy gained steam. Although this is being rolled back, it’s a card the Fed can choose to play in a time of crisis.

If all things were equal, the movement of the bond market in one direction or another on a particular day would determine your mortgage rate. However, your personal financial profile is taken into account as well. Let’s get into that next.

Your Personal Interest Rate

Your personal interest rate is dependent on a variety of factors. We’ll cover the major ones in detail here, but you can check out this post on getting the best possible mortgage rate for more detail.

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An important thing to remember about mortgage rates is that in addition to market factors, they’re also determined in part by the level of perceived risk. If you’re considered a lower risk, you’ll get a better rate than someone with higher risk factors.

Among the metrics lenders use to revalue your qualifications are your credit, the size of your down payment and the type of property you’re buying or refinancing.

On top of these, we’ll also discuss how closing costs can affect your rate.

Understanding Risk Factors

The first important factor in determining your interest rate is your credit. The thing you often think about when you think of credit is a FICO® score, and that is certainly a major factor, but you may also want to keep an eye on a few other items.

Of particular relevance to your interest rate is whether you have negative items, such as a bankruptcy, on your credit report. If the negative item is too new, you can end up with a higher interest rate even if you do qualify, due to fewer programs being offered and the higher risk for the lender or mortgage investor.

In addition to credit, another huge element is the size of your down payment or the amount of equity you have in the home you’re financing. A higher down payment means less risk for the lender or mortgage investor, enabling them to give you a lower rate.

The final big risk factor affecting your interest rate is the type of property you’re buying. All other things being equal, your rate will be lower for a primary property than it would be for a second home or investment property. The rationale here is that if you run into financial trouble, you’re more likely to make the payment on your primary property first.

Closing Costs and Your Rate

Another thing that can impact your rate is the closing cost associated with your loan. Let’s briefly go over a few examples.

Prepaid interest or mortgage discount points are a way to buy down your interest rate. One point is equal to 1% of the loan amount. Whether it makes sense to buy points involves doing a little bit of math.

Let’s say you’re buying a $200,000 home and paying for two points will save you $50 on your monthly payment. Since the cost of the points would be $4,000 (200,000*0.02), you divide this number by 50 in order to get the break-even point: 80 months. In other words, if you plan on staying in the house for more than 6 years and 8 months, it can make sense to buy the points, because you’ll save money over time. Otherwise, you shouldn’t buy the points, or you should buy fewer points.

On the other hand, if you want to keep closing costs down, you can opt to take a credit from your lender to roll the losing costs into the loan  in exchange for a slightly higher rate.

Finally, if you make a down payment of less than 20%, you’ll likely have to pay for mortgage insurance or an equivalent. The exception to this is VA loans, which have a one-time upfront funding fee that can be rolled into the loan if desired.

With conventional loans, you have the option of making the mortgage insurance payment on a monthly basis or having the lender pay for the policy upfront and taking a slightly higher interest rate compared to loans without lender-paid mortgage insurance (LPMI). However, there is also something called single-pay mortgage insurance. With this option, you can pay for part or all of your mortgage insurance policy upfront to get a lower rate while still avoiding a monthly mortgage insurance payment.

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Understanding Mortgage Investors

Now that we understand how rates work, let’s take a quick look at some of the other aspects of the mortgage market.

As mentioned above, the mortgage investor plays an important role in providing cash flow in the mortgage market, but who are they and what do they really do?

Who Are the Mortgage Investors?

In some cases, the bank that originated your loan is also the investor in that mortgage, but this has become less and less common in recent years. Most loans nowadays are sold to one of five major mortgage investors:

  • Fannie Mae
  • Freddie Mac
  • Federal Housing Administration (FHA)
  • S. Department of Agriculture (USDA)
  • Department of Veterans Affairs (VA)

Fannie Mae and Freddie Mac provide what are referred to as conventional or agency loans and are government-sponsored entities (GSEs). The last three are loan options offered by the federal government and really roll up to one investor, Ginnie Mae.

Each investor has strict standards regarding which loans they’ll buy, and that helps determine what loan type you qualify for.

What Do Mortgage Investors Do?

Mortgage investors buy mortgage loans and then provide insurance. Essentially, they allow bond market investors to buy the loans with the confidence that even if several people in a pool of 100 or 1,000 loans default, the regular investor in the bond market won’t lose their shirt.

In exchange for this insurance, these initial investors act as the middleman between the originators and the bond market at large. They package the loans up into an MBS and mark up the price a bit for a profit. There is also sometimes a difference in the appetites for certain types of loans, which can account for differences in interest rates between FHA and conventional loans of the same term, for example.

What Happens When Your Loan Is Sold?

Because mortgage investors buy your loan from originators, it’s likely you’ll receive a notification that your loan has been sold to an investor within a month or two after your closing. However, that doesn’t necessarily mean your relationship with your lender is ending.

After closing, you then enter the servicing phase of your loan transaction until the house is sold, refinanced or otherwise paid off. In addition to collecting your monthly principal and interest payments, the servicer will also collect monthly for your property taxes and homeowner’s insurance, if you have an escrow account, as well as for your mortgage insurance, if applicable. If you run into financial trouble and need payment assistance, you would also contact your servicer then.

While some lenders sell the servicing rights to their loans, Quicken Loans is proud to service 99% of the loans it originates. We’re your lender for life and will stay with you from application until you make your last payment.

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