Harbaugh Real Estate

What Drives Mortgage Rates Anyway?

By Lee Harbaugh

Over the past year, we have heard much talk about the rise in mortgage rates. But, why exactly do mortgage rates rise? Or, for that matter, why do they fall ?

a graph depicting rising mortgage rates

In January 2021, the average 30-year mortgage rate in the United States hit a historic low of 2.65% according the the Federal Reserve and Freddie Mac. In 2021, rates rose slightly and closed the year at 3.11%. Since then, mortgage rates have been on a tear, with the 30-year rate peaking at 7.08% in November 2022 before settling at 6.42% by year's end.

The FED Does Not Directly Set Mortgage Rages

The first thing to be aware of when it comes to understanding the mechanics behind mortgage rates is that the Federal Reserve does not directly set mortgage rates. The Fed's Open Market Committee is responsible for setting the fed funds rate, which is the rate that banks charge one another on overnight loans. This is the rate upon which pretty much every other rate in the country is based. Think of it like this: If it's costing the bank more to borrow money, they're going to charge you more to borrow money.

The FED Is Not the Only One Who Influences Mortgage Rates

If you've paid attention recently, you may have noticed that mortgage rates have not necessarily moved in lock-step with the Fed's rate moves. This is because mortgage rates are largely driven by investors.

Generally speaking, when you or I purchase a home and get a new mortgage, the company that sells us the mortgage is going to turn around and sell that mortgage to a secondary company who then bundles our mortgage with many other mortgages and sells that as one security to investors on Wall Street. This process is called securitization, and the resulting security is known as a Mortgage Backed Security (MBS).

Mortgage Rates Closely Follow the 10-Year Treasury Note

Thus, mortgage rates are more closely tied to the 10-year treasury than any other rate. If the yield on the 10-year note goes up, mortgage rates will likely go up as well, and if the 10-year yield goes down, mortgage rates will follow.

Now, you may be asking what drives the 10-year note, and that is a good question. Ultimately, the price of any security is driven by supply and demand. When supply exceeds demand, prices tend to go down, and when demand exceeds supply, prices tend to rise. Bonds are a bit of a strange animal. The yields on bonds move inversely with their price. So, when the price of a bond goes down, the yield necessarily goes up and vice versa. When there is a huge demand for 10-year notes, the price goes up, and the rates tend to fall. If there is suddenly a large demand for 10-year treasuries, mortgage rates will tend to go lower.

Mortgage Backed Securities Also Have Their Own Market

Having said all that, nothing ever happens in a vacuum, and mortgages are no exception. While they do tend to follow the 10-year note, they also follow themselves! As with any market, if there are more MBS on the open market, the prices will tend to be lower, and the rates higher. This is so because a new investor would be able to purchase an existing MBS at a lower price than they can purchase a brand new MBS if both have the same interest rate. In order to attract investors to new securities, the rates have to go higher.

One of the results of the financial crisis of 2007-2009 was that the Fed purchased a whole bunch of MBS in order to keep the market from completely tanking. Until now, they have simply held those securities on their books. When they started raising rates last year, one of the things they did to raise the rates was start selling some of those securities. The result has been that the MBS market has had more supply and less demand. Again, this has resulted in the prices of these securities going lower and consequently mortgage rates going higher.

Wrapping it All Up

OK, so I've talked briefly about some very complex topics here. As you might expect, there are numerous resources on the web that explain more about each of these components. Below are some links that you might find helpful:

Investopedia article about factors affecting mortgage rates

Investopedia article about the effects of the fed funds rate on your bond portfolio

Forbes article about what drives mortgage rates