For people who want to get a mortgage, you may have questions about how the bond market can make mortgage interest rates go up and down. Bond rates affect mortgage rates because they compete with each other as investments. Both are attractive to investors who want a stable, fixed return, with a relatively low risk.
For many decades, there has been a clear connection between the bond market and mortgage rates, but there are three major reasons that bonds are lower risk investments:
- Bonds are usually loaned to cities, companies and countries and are likely to be paid back.
- Bond rating agencies study every company and bond and tell investors how risky they are.
- Bonds may be resold to the public. This means that a bond is easily traded. So, the investor does not need to keep the bond throughout its life.
Most bond investors want low risk, but there are some higher risk bonds available, such as junk and emerging market bonds. Meanwhile, the safest bonds are US government treasury notes and the majority of municipal bonds.
Mortgages have a higher risk than most bonds because they are 15 or 30 year mortgages. They are in direct competition with US treasury notes. Investors who don’t want their money for many years may want to invest in mortgages because the rate of return is higher.
Banks leave interest rates on mortgages a few points above than US Treasuries. Because US Treasuries are backed by the US government, they are very safe and investors don’t need a high rate of return. As the interest rates on US Treasury notes go up, banks can increase interest rates on new mortgage loans that are issued. So, this means that first-time homebuyers have to pay more every month for the same loan. They have less to spend on the actual cost of the home. In most cases, when interest rates go up, housing prices go down.
Treasury bonds have the lowest rate of return, but they have a major effect on the interest rate for mortgages. This is because investors who want to invest in mortgage-backed securities want a higher rate of interest on higher risk securities than what is offered with US Treasuries – the safest investment of all. When bond rates or yields go up, interest rates on mortgages will usually go up. However, you should note that with bond prices, the relationship is inverse. When bond prices go up, mortgage interest rates go down.
Mortgage backed securities are backed by mortgages that US banks loan. Instead of holding them for 15 or 30 years, the banks then sell the loans to Fannie Mae and Freddie Mac. They are bundled together and sold on the secondary market and are bought by big banks and hedge funds. This was the major source of problems in the recent financial crisis; the mortgage backed securities had high numbers of subprime mortgages that went into foreclosure. It is interesting to note that higher Treasury note rates did not have a major effect on housing in 2012 and 2013. In fact, home prices rebounded by 30% or more across the US. This was a good signal to many real estate investors. As the prices went up, they started to think that investing in homes was a smart investment. Still, interest rates have stayed quite low, with only recently (November 2016) interest rates going above 4%.
More About Bonds
Investors like to turn to bonds when the economy looks poor. When the purchase of bonds go up, the yields fall, and mortgage rates also fall. But when the US economy is thought to be doing well, investors tend to go into stocks and this forces bond prices down and pushes the yield up. And mortgage rates go up too. A really good way to know which was mortgage rates are going is to check the 10 year yield for bonds. This can be found on most financial websites. If the 10 year bond yield is going higher, mortgage rates are probably on the way up.
To have a good idea of what the current 30 year fixed mortgage rates are, we recommend using a spread of ~170 basis points, which is 1.7% above the 10 year bond yield at present. The spread is accounted for because of the higher risk that is associated with a mortgage note. If the 10 year bond yield is 4%, an additional 170 basis points means that mortgage rates will be in the area of 5.7%. Note that the spread can vary over the years, but this is a good baseline to give you an idea of where mortgage rates may fall.
If you are shopping for a mortgage and plan to buy a home in six months or a year, you would be wise to watch the 10 year bond yield to see what rates are doing over the weeks and months before you buy your home. Also, keep a close eye on the general economic news. If the economy is doing poorly, interest rates will usually drop, and the opposite happens when the economy is growing strongly.
If you buy your home in a period of rising interest rates, you may not be able to afford as much home as when interest rates are falling. An increase in mortgage rates of 1 point can mean that you are paying $100 or more for your loan each month, which can put a more expensive home out of reach for some buyers.