My Crystal Ball is Broken
Whenever I have a client who goes under contract or is working on a refinance, the conversation comes up on whether they would like to lock their interest rate, which means agreeing to a specific rate and cost for that rate for a specific number of days with the lender, or float the rate, which means we would continue processing the application while remaining subject to the market fluctuations up or down. Invariably, I get the question, “Where do you see rates going?”
I’m here to tell you that anyone who tells you they know the answer to that is lying to you unless you caught them on a grocery run from their private island that they purchased with the proceeds of their incredible ability to time the market. If they’re working for a living, they’re making an educated guess. Here’s how I do that:
At the end of the day, mortgages are priced based off whether anyone is willing to extend credit at those terms. For most mortgages, which follow a defined set of guidelines on documentation and credit risk, the determining factor in demand for that loan is based of whether investors are willing to buy the loan (or, more typically, the security made of a lot of loans) at a given rate and cost. There are two main indicators we follow to try to predict this, though past trends do not always predict the future. Neither of them is “the fed cutting rates” for what it’s worth.
First: The 10 Year Treasury Bond
Mortgage Rates vs Yield against 10 year US Treasury
When investors are choosing where to allocate funds, the closest comparable investment is the 10 year treasury bond, which has a comparable term to the average mortgage, since most mortgages are not held for the full 30 years. A treasury bond is comparatively lower risk, since the entity repaying it is the government and not a series of consumers, and lower cost to create. Therefore, in order for mortgages to be a worthwhile investment, there must be a premium paid on the interest rate by a mortgage backed security versus a treasury bond to make the additional risk worthwhile.
The graph above shows average mortgage rates over the past 10 years in orange, along with the shaded area representing the average yield, which is the difference in rate paid compared to the 10 year treasury. This spread has two factors: the primary spread, which reflects the costs to originate the mortgages, and the secondary spread, which is what the end investors demand to see in order to purchase the mortgages. During the historically low rates in 2020 and 2021, this spread was low, because the economic outlook was uncertain for other investments which drove investors into the comparatively safe mortgage backed securities, along with a very low 10 year treasury rate.
Mortgage Rates shown as 10 year treasury plus spreads
Due to inflation driving the 10 year bond up, rates started to rise in 2022, and as that sharp increase occurred, so did the investor’s need for additional spread against the treasury to account for their increased risk. Higher rates mean higher risk of early payoffs via refinancing, so the investors wanted to have a higher return to account for their anticipated shorter timeline holding the loans. Costs to originate loans increased at that time as well, as the volume of mortgages being originated sharply decreased and fixed costs were being spread across fewer loans for originators.
Our second factor in mortgage rate pricing is the price of Mortgage Backed Securities, but as is typical, I’ve written too much and will have to save that for another day!
