The press is filled with stories about higher mortgage rates. Experienced brokers tell their borrowers, however, that rates are just one part of the home financing story. Excellent service is very important, as is offering the right product for the right borrower and right situation. That said, many of your clients will ask how mortgage interest rates are determined. Rates have climbed dramatically through May and into August, despite the feeling they should not have been increasing by as much as they have. The quick answer is that supply and demandset prices: the higher the prices, the lower the rates. But what determines supply and demand?

The supply side of the equation is determined by the amount of mortgage originations there are. Demand is determined by investors’ (such as money managers, insurance companies, and pension funds) expectations of what will happen in the economy in the future. If investors think there will be inflation they will require a higher rate of return, demand will shrink, and rates will go up. The more detailed answer is the value of the investment is determined by the rate of return. Lenders like Orion usually do not keep their mortgages but rather bundle them into huge pools and sell them to Fannie/Freddie/Ginnie. By selling the mortgages the lender reloads on cash, which they then use to fund more mortgages.

In general,the demand for any fixed-income security will be based on future inflation expectations. In addition, risk matters: the riskier the asset, the higher rate the borrower or issuer will have to pay. Is a particular borrower a better credit risk than IBM, or Coca Cola? If they are, then they’d pay a lower rate. Investors are willing to forego some profit for the stability of the investment, but they put their money in depending on their best guess as to what will happen in the future and how they can maximize their return. The U.S. Government doesn’t guarantee the repayment of debt of IBM or Coca Cola, but it does offer backing of several home loan programs, predominantly FHA and VA.

For the past several years the Federal Reserve has been impacting the demand side of supplyand demand by purchasing billions of dollars of mortgages. The QE policy, which ended many months ago, drove interest rates lower and assisted the housing market in recovering from the collapse. The recent increase in rates is mostly based on speculation that the Fed will continue to keep rates high to combat inflation. This will lower the demand for mortgages; less demand with constant supply will drop prices.

To summarize, investors speculating on supply and demand and the future economic conditions determine interest rates. But know that, while rates are important in determining home affordability, Orion’s brokers know that products and service are very important as well.

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