What is a Mortgage?
When people want to buy something now, but don’t have (or don’t wish to spend) the cash to buy it outright, they can instead use a loan (aka financing, borrowing, debt). This typically involves an agreement between the consumer and a lender. The lender provides the big chunk of money today (that big amount that the consumer didn’t want to, or couldn’t spend) and the consumer agrees to make payments back to the lender over time. An example of this that almost everyone will be familiar with is auto financing (i.e. car payments).
A mortgage is simply the financing of a home.
Like an auto loan, a mortgage allows the consumer to legally own the underlying asset (car, home). Like auto loan paperwork, mortgage paperwork allows the lender to take back or “repossess” the underlying asset (aka “collateral”) if the consumer doesn’t pay as agreed, although the process is much more complex and time consuming. The idea is that if a consumer isn’t willing or able to honor the agreement, the lender can recoup some or all of their initial investment by taking the collateral (i.e. home, car) back and selling it.
What’s in it for the Lender?
Lenders don’t tend to lend money simply because consumers want loans. Lenders make money by offering loans because there is typically an interest rate attached to the loan.*
*0% auto financing is a notable exception, but that’s typically only offered via factory financing in order to sell more cars. Also, as you’ll see in our article about upfront costs versus monthly payments, a 0% payment rate doesn’t necessarily mean a consumer is being charged 0% interest overall. For instance, the auto buyer with the 0% loan may have had to choose that loan over, say, a $1500 cash back incentive. In that case, the buyer effectively paid $1500 in interest upfront in exchange for paying less over time.
Interest is additional money beyond amount borrowed that allows the lender to profit from the transaction. In the mortgage world especially, interest and interest rates are fairly complex topics. Other articles in this series will help you learn as much as you want to know about mortgage rates.
Key Concepts
Mortgage rates are interest rates on home loans
There are really TWO mortgage rates: the interest rate (or “note rate”) applied to your loan amount (or “principal”) and the rate implied by certain upfront costs (the “effective rate”).
APR (Annual Percentage Rate) attempts to convey that “effective rate.”
Understand the tradeoffs between upfront costs and payments over time
Principal (definition): the current balance of a loan/mortgage. In the absence of any additional costs or fees, the initial principal balance of a mortgage is whatever was borrowed to buy the home. Let’s say you buy a $200,000 home and are able to make a $10,000 down-payment (an upfront payment that reduces the amount of money borrowed). The principal in this case would be $190,000.
Principal also refers to the remaining balance after a mortgage payment. Each payment is typically contains some interest for the lender and can also contain property taxes, homeowners insurance and mortgage insurance. Whatever is left over goes toward reducing the principal balance (the amount you owe, which is slightly different from a “payoff balance”). In other words, as you make payments, the amount you owe decreases. When that amount reaches zero, you own the home outright!
Payoff vs Principal: If you’ve refinanced or sold a home before, you may have noticed that the amount required to pay off the old mortgage was slightly higher than the principal balance on the mortgage. This occurs because your monthly mortgage payment covers interest charged during the previous month. If you pay-off your loan in the middle of any given month, the lender hasn’t yet collected interest for that month. They’re not going to charge you for the entire month, however, only the number of days between the 1st of the month and the payoff date.
For example, your mortgage payment on June 1st would cover interest for the month of May. If you pay off your loan on June 10th, the lender has not yet been paid interest for those 10 days, and will add them to your payoff amount. This is true for both purchases and refinances. Many lenders charge a small additional fee to obtain the payoff balance for administrative costs associated with an early payoff.
Mortgage Rates are simply the interest rates applied to the principal balance, but there is an important distinction. What most people refer to as “mortgage rates” are actually only part of the equation. The more accurate term would be “note rates.” This refers to the interest rate on the promissory note (an official document that you’ll sign during the mortgage process).
Think of the promissory note and the note rate as a sort of baseline for the overall cost of financing. While it’s true that the note rate is 100% responsible for determining the monthly mortgage payment, it’s typically NOT the only cost of financing. Most mortgages have an “upfront cost” component.
Upfront costs are charged by multiple parties (examples include: lender, appraiser, credit bureau, local government taxes, homeowners insurance companies, attorneys/title company, etc.) Most of these costs will not change regardless of the loan type or the lender, but some will.
Upfront lender-related fees are common. They add to the overall cost of financing. Therefore, the NOTE rate differs slightly from the actual or “effective” rate you’re paying on your money.
The Truth In Lending Act stipulates that lenders must quote that effective rate in the form of APR or annual percentage rate. If you don’t read anything else on APR, it’s important to know that not all lenders calculate them the same way, and APR can’t necessarily be trusted as an apples to apples comparison between two or more lenders.
For the purposes of understanding mortgage rate building blocks, we’ll simply use the term “upfront costs.” Whether we’re talking about the interest portion of your mortgage payment or upfront lender-related costs, it’s all money that ends up going from your wallet to the lender. In most cases, you have some say in dividing up the lender’s upfront income versus their income over time.
For instance, you will typically have the option to pay more upfront in exchange for a lower interest rate. The industry has long referred to this type of extra upfront payment as “points” or “discount points.” Despite any negative connotation from certain financial media pundits, points are neither good nor bad--simply a choice to pay now or pay later.
Only you can decide which way makes most sense for your scenario. The only thing that really matters is the trade-off between the two choices.
If you invest your extra cash and earn a certain rate of return, you may be better off minimizing your upfront costs and putting that money into your investments.
If, on the other hand, you wouldn’t be earning a great return on that money and you know you’ll have the mortgage for a long time, it may make sense to “buy down” the rate with additional upfront cost.
Your lender should be able to show you the difference between those options in terms of the number of months it will take to break-even on the additional upfront cost. For example, you would pay $1200 in extra upfront costs and $14 less per month in scenario B. It would take 86 months to break even because $1200/$14 = 86.
SCENARIO A:
Upfront costs: $5000
Payment: $2000 per month
SCENARIO B:
Upfront costs: $6200
Payment: $1986 per month
86 months (or 7.16 years) is a fairly typical break-even time frame when you buy-down your rate. Break-evens vary from lender to lender and from rate to rate. In cases where the break-even time frame is 4-5 years or less, it’s an increasingly compelling option for people who plan to keep the new mortgage for a long time and who don’t have a great place to earn a high rate of return.
The bottom line is that it’s your choice and there’s no right or wrong way to do it.
In terms of understanding mortgage rates, the important concept is that of “upfront cost” vs “cost over time.” For any interest rate you hear about or see online, there are certain assumptions underlying that quote. It could be based on higher upfront costs than you had in mind or a higher credit score than you have (read more about how credit and other individual factors can affect rate. You won’t ever be able to know the actual rate until you know what those assumptions are.
NOTE: In lieu of choosing a mortgage with a higher rate and lower upfront costs, you may be able to increase the new mortgage balance in order to pay the costs--sometimes referred to as “rolling in.” This would keep the interest rate the same, but the payment would still be slightly higher because the loan balance is slightly higher. You’d also need to consider the fact that you’ll have more principal to pay off when it comes time to sell or refinance. Even then, this can sometimes be a more appealing option than raising the rate to cover the costs--especially if the upfront cost savings happens to be minimal between the quoted rate and the next rate higher (remember, they vary from rate to rate and lender to lender).
What Causes Mortgage Rates to Change?
Mortgage rates change daily, and sometimes multiple times per day. In this article, “mortgage rates” will refer to the combination of upfront cost and actual interest rate described here: The 2 Components of Mortgage Rates. For example, if we talk about “higher rates,” it could either mean that the interest rate is higher, or simply that the upfront cost is higher for the same interest rate.
These frequent changes are not arbitrary in any way. Instead they are the result of multiple factors with varying levels of importance and interdependence. Mortgages exist because investors want to earn interest by offering loans. Because of this, mortgage rates end up being directly driven by all the various market forces and operational considerations that dictate what those investors can/should/must charge.
Factors relating to market forces
Much like mortgage borrowers need money to buy a home, the US government needs money to finance Federal spending. Political commentary aside, this creates a massive market for government debt, which in turn serves as the plainest, most risk-free benchmark for many other types of debt. Collectively, this is known as “the bond market.”
There are many other types of bonds with varying levels of risk and different features. They all exist because investors need or want to lend money and various entities need or wants to borrow money and. Mortgage borrowers are one such entity. When lenders have enough of the same type of loan from mortgage borrowers with similar circumstances, those loans can be grouped together to form a bond that can then be sold to other investors. Once the mortgage lender sells those loans to other investors, they now have the cash flow to go make news loans—assuming there are other investors who are interested in buying more loans.
Thus, a market for these mortgage-backed-securities (MBS) is born. It’s quite a bit more complex in practice, but generally speaking, it’s simply a market for groups of loans. These trade on the open market and tend to follow the broader movements of more mainstream bonds like US Treasuries. In short, all the factors that can affect interest rates in the bond market can also affect the price that investors are willing to pay for these groups of mortgages. Those prices have a more direct influence on the rates that mortgage lenders can offer than anything else!
Bottom line: loans become mortgage-backed-securities which trade on the open market, and the prices of mortgage-backed-securities dictate the rates that lenders can offer to new mortgage borrowers.
Factors relating to operational considerations
Knowing the price that investors are willing to pay for a group of similar mortgages gives lenders a baseline for the costs they must charge borrowers. The lender’s operational considerations will account for the rest. These considerations are all directly or indirectly related to how much profit the lender wants to make or how much business they are capable of doing.
For instance, we tend to think of banks as always being available to make loans to borrowers who fit the right criteria, but that isn’t always the case. Many mortgage lenders have a certain amount of cash flow that they’d ideally like to use over a certain time frame. If a lender isn’t on pace to lend as much as they’d like, they might lower rates in order to entice more business. Conversely, if a lender is on pace to lend out more money than it has, it could raise rates in order to deter business.
Apart from the availability of funding, lenders must also consider the availability of personnel. It takes human beings to make loans happen, and at a certain point, a lender will be at capacity. It can then either hire more staff or simply raise rates to throttle the amount of incoming business.
These are two of the most basic operational considerations for lenders that complement the actual market-driven prices of mortgages. This can be thought of as any sort of business that sells a product made from raw materials. A car company, for example, is greatly affected by the cost of steel and aluminum, but the cost that buyers end up paying is also greatly affected by how that car company does business. How many factories do they have? How well-trained are their employees? How efficient are they?
In the mortgage world, mortgage-backed-securities would be like the steel and aluminum while individual lenders would be like auto manufacturers, each trying to build/sell cars as efficiently and as profitably as possible.
Bringing it all Together
The lender-specific considerations certainly change and certainly account for a portion of any given mortgage rate offering. Quite simply, this is why different lenders offer loans at different rates even though they’re all working with the same raw materials.
But it’s those raw materials—those mortgage-backed-securities—that move throughout the day and do most to affect the moment-to-moment changes in lenders’ rate sheets. If something in the world is happening to cause investor demand to increase in bond markets, MBS tend to benefit as well. When MBS prices rise, investors are willing to pay more for those bundles of loans, meaning that lenders may be able to offer lower rates. Conversely, if investors are seeking riskier investments for whatever reason, MBS prices could fall, meaning investors aren’t paying as much for mortgages, thus forcing lenders to raise rates.
How Are RATES Determined?
Key Concepts
Mortgage rates are driven by investor demand
Investors view mortgages as similar to bonds (lower risk, more stable return)
Unpredictable consumer behavior makes mortgages more risky than “guaranteed” bonds like US Treasuries
Investors expect higher rates of return for riskier scenarios (i.e. lower credit scores = higher mortgage rates, etc)
We’ve covered the building blocks of mortgage rates. Now let’s discuss where mortgage rates come from. How are they decided? Why can they change? Why can they be so different from person to person?
SIMPLE VERSION:
At their most basic level, mortgages are like bonds (fixed-income investments where an investor fronts a lump sum and is paid back over time with interest). There are many types of bonds in the bond market and those that are similar to each other tend to move in the same direction based on investor demand. Movement in the bond market generally translates to movement in mortgage rates.
From there, lenders make additional adjustments to rates based on things like credit scores, down-payment amounts and other risk factors. Those adjustments rarely change, so day to day movement in an individual rate quote is almost always determined solely by bond market movement (unless your credit score rapidly changes or you decide to put a different amount of money down).
DETAILED VERSION:
As discussed in our “What is a Mortgage?” article, the existence of mortgage rates depends on investor demand. At the simplest level, someone with money has to be interested in giving it to you so you can buy or refi a home and pay them back with interest over time.
Given that the investor could buy other investments (stocks, bonds, currencies, etc.) something about your mortgage has to get their attention. There are several pros and cons of investing in mortgages, but the most important factor is that mortgages offer a competitive rate of return without much more risk, compared to similar investments.
When we talk about similar investments, a mortgage would be most similar to a bond. A bond is considered a “fixed-income” investment because an investor pays a lump sum upfront in exchange for a fixed schedule of payments over time. Payments could occur monthly, semi-annually, etc.
Unlike most fixed-income investments, the borrower in the case of mortgages is a consumer. Contrast this to the biggest category of fixed-income borrowers: entire countries! For example, when it comes to US Treasury notes and bonds the borrower is the United States Treasury.
While the US and other major borrowers make debt payments for a guaranteed amount of time, consumers have choices when it comes to their mortgage. Consumers can CHOOSE to refinance or sell. That means the investment is retired. The investor gets their initial principal back and perhaps some of the interest they’re entitled to for the current month, but no further monthly payments. This could happen weeks, months, or years into a mortgage.
Other situations like foreclosure or short sale also prematurely end a mortgage. In some cases, the investor could lose some of their initial principal, but due to the structure of the mortgage market, that’s a rare occurrence these days. The unpredictable nature of consumers selling or refinancing is a much bigger issue.
Why would an investor care about getting their principal back early? Simply put, the investor is counting on making their money by collecting interest over time. In fact, investors often pay a premium for the right to collect monthly payments on a mortgage. If something cuts those payments short, the investor could LOSE money.
Here’s a practical example showing why an investor wouldn’t want to be paid back early:
$100,000 = Mortgage Loan Amount (principal)
$104,000 = What an investor might pay a mortgage company to obtain the loan
In this example the principal balance is still $100k. The investor paid a premium to obtain $100k of principal because the interest rate was attractive relative to other investment opportunities. The investor could have paid nothing for a loan with a substantially lower rate, but this rarely happens in the modern mortgage lending environment. Naturally, any time before the total amount of interest in the above example reaches $4k, the lender would like the borrower to continue making payments.
It’s worth noting that most mortgage transactions don’t simply involve one investor buying one mortgage. Investors will either buy lots of mortgages (so they are more likely to have plenty of mortgages remaining even if a few of them are paid back early), or they will simply buy a chunk of the same sort of portfolio. When multiple, similar mortgages are grouped together and sold off in those “chunks,” it’s a process known as securitization.