There are two main types of mortgage loans: fixed rate and adjustable rate. For anyone involved in the real estate sector, having a solid grasp of what specific economic factors directly influence interest rate fluctuations is essential for making knowledgeable financial choices such as knowing when to go with a fixed-rate mortgage instead of an adjustable-rate mortgage (ARM) or choosing the appropriate time to refinance.
Understanding Mortgage Rates
The mortgage interest rate is the percentage of the outstanding principal loan balance the borrower pays to the lending entity in exchange for borrowing the money to acquire real property. There are a number of economic conditions that can play into what interest rates banks charge their borrowers. The central bank for a given country is responsible for dictating the interest rate, which all other subordinate banks reference when setting their individual annual percentage rates (APRs). Rising inflation typically prompts central banks to bump up interest rates, raising the cost of debt which disincentivize borrowing and tempers demand levels.
The mortgage industry can be divided into three distinct sectors:
- Origination: Lending institutions such as credit unions, banks and private lenders act as mortgage originators. They produce, advertise and sell funding options to borrowers in a competitive marketplace—each attempting to offer more attractive terms, lower fees and better services while still garnering a profit. The vast majority of mortgage originators opt not to do portfolio loans in which they keep the loan asset. Alternatively, they usually auction the mortgage in the secondary market.
- Aggregation: Mortgage aggregators purchase recently originated mortgages on the secondary market then pool comparable mortgages together to establish mortgage-backed securities (MBS)—which is a process called securitization. MBSs are marketed to investors as bonds secured by an underlying group of mortgages. The going rate for MBSs dictates the price that aggregators are willing to shell out for originated mortgages from lending institutions and the interest rates that they will extend to borrowers if they originate their own mortgage products.
- Investment: There is a large number of MBS investors, ranging from pension, mutual and hedge funds to insurance entities and the notorious government-backed enterprises Freddie Mac and Fannie Mae. In an attempt to optimize returns, investors often conduct relative value analyses comparing MBS and alternative fixed-income investment options such as stocks to settle on a price they are willing to pay. MBS investors play a key role in controlling the mortgage interest rates extended to borrowers.
Fixed-Rate Mortgages
The term ‘fixed-rate’ means that the interest rate is fixed for the entire duration of the mortgage. The borrower pays a constant interest rate from the start to end of the loan. MBS prices are largely dependent on the value of U.S. Treasury bonds. Typically, the price of a MBS backed by 30-year mortgages will fluctuate proportionately with the yield of a U.S. Treasury five-year or 10-year note—a financial concept called duration. The general economic environment influence how much U.S. Treasury bonds are worth. Accordingly, when inflation rises, bond values drop and their yields increase.
Adjustable-Rate Mortgages (ARMs)
Interest rates for adjustable-rate mortgages (ARMs) fluctuate periodically depending on the specific terms of the loan. The interest rate is comprised of an index value in addition to a margin in what is referred to as the fully-indexed interest rate. The index value changes, whereas the margin remains constant for the entire course of the mortgage. There are a number of different mortgage indexes applicable to varying ARMs, all of which are premised on interest rates on either a form of actively traded financial security, bank loan or deposit. All of the indexes usually change in tandem—trending up and down together depending on the market.
Interest Rates & The Housing Market
Interest rates ultimately control how much homebuyers will have to expend in order to acquire real estate assets. When interest rates decline, the demand for property rises and the value of real estate skyrockets. Currently, interest rates are still at or near historic lows—making it the perfect time to obtain financing for a real estate investment. While the market is competitive, there are still many viable options our there for savvy investors.
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Founded over a century ago, F.E. Forbes Company is a Berkeley-based rea estate investment management and private money mortgage lender specializing in the origination of both residential and commercial loans secured by Northern California real estate. Contact us today to learn all about your funding options and find the perfect fit for your next project.
