The single most common question most Loan Officers get is “What determines your interest rates?” To this, unfortunately, there is no simple answer to what determines mortgage rates in New Jersey. In fact, a variety of factors lend their hand in the determination of where a particular lender will be on rates. Generally, within a given product line, most lenders will be within 3/8% of each other on a given rate in a given day for the same type of mortgage. The primary reason for this is that most mortgage rates ultimately come down to where the Federal treasury markets, and consequently the mortgage-backed security markets are trading.
What Determines Mortgage Rates?
The Fed and Bond Markets influence
To understand these markets, we first need to understand Fixed Income Securities and the Federal Reserve. Federal treasury markets refer to the United States Treasury Bonds that are traded on Wall Street. This is known as a fixed-income securities market since it pays out a fixed income over time based on an up-front investment. The cost of that investment, in this case the treasury bond, will go up and down depending on market conditions and speculations. When the price of the security rises and falls, the return on that investment is affected and thus the real “yield” or “rate of return” goes up and down as well. This rate of return is commonly referred to as the interest rate. Clients in this market will buy or sell treasuries depending on how they feel the economy is doing and where rates will be in the future. If the speculators believe that the prices for Treasury Bonds will be going up, which in turn would drive down the yields, they will buy now, knowing that they can ask more money for their current higher priced treasuries down the road. If, however they believe that the prices will be going down on these notes, the speculators will sell now, as they would with any commodity. Thus, in this way, treasury bill rates are determined.
Some of the factors that would be driving individuals’ decisions in these markets include, but are not limited to, speculation about inflation, economic growth, and where they believe the Federal Reserve (The Fed) will stand on Monetary Policy in the future. The Fed will consider factors such as inflation and strong economic growth when making its decision on rates. Higher economic growth generally means a higher risk of inflation. Since inflation erodes the value of the dollar and consequently purchasing power within the economy, the Fed may consider hiking rates to stem the ability of corporations to borrow money. This will generally slow the economy in an effort to curtail inflation. Conversely, the Fed may cut rates if it feels that the economy is sluggish. This, in turn, would stimulate the borrowing power of banks and corporations to increase production and growth in the economy.
The Fed can use its monetary policy to cut or raise either the Discount Rate or the Federal Funds rate. The Discount Rate is the rate charged by the Federal Reserve Banks for short-term loans made to member banks. The Federal Funds Rate is the rate of interest charged by one institution lending federal funds to another. Through a combination of these rates, the Fed can influence the direction of the national economy. It generally will examine the prudence of these rates and whether they should move them when it meets to discuss strategy.
Wall Street, in its infinite wisdom, is aware of the Fed’s power and is constantly trying to predict, as it does generally with a relatively high degree of accuracy, what the Fed’s next move will be. It is these predictions to the Fed’s move, much more than the reactions to the Fed’s move, that will influence Treasury Bonds, Mortgage Backs, and consequently Mortgage Rates. Once the Fed makes their move, Wall Street will then move on to what they anticipate the next move will be.
A common question asked of mortgage lenders is “Since the Fed cut rates when will your rates be going down?’ The obvious answer, under most circumstances, is “Our rates have already been adjusted downward based on the prediction that the Fed would be forced to move.” There would only be a couple of exceptions to this rule. The first would be if the Fed did not follow the predictions of Wall Street at its meeting and decided to move rates against the better judgment of the market. This is uncommon however it does occasionally happen. The other exception to this would be if the Fed decided to move rates between its meetings. The Fed may do this for a number of reasons, not the least of which may be to re-emphasize to Wall Street its resolve towards the direction in which it is moving and perhaps to “shock” the economy and the markets. It would be appropriate for the Fed to make this move if they felt, for any reason, that the economy could not, or should not, wait until its next meeting.
Much the way that Treasury Bills react to the anticipation of what the Fed’s next move will be, the Mortgage-Backed Securities markets react to predictions about Treasury Bills. Mortgage-Backed Securities involve investments that are tied to the mortgage markets. Mortgage Backs, like treasury notes, are fixed-income security and involve bundling mortgages together and selling them in bulk on the market. Due to the need to provide their investors with better rates of return than Treasuries due to their riskier nature, the mortgage-backed market will always be priced just lower than T-Bills, thus returning a higher yield on investment. Since most mortgages pay off within 10 years, the mortgage-backed securities market will generally pay closer attention to the rate of the 10-year treasury bill than any other note. If you want to know the general direction of mortgage rates, the 10-year treasury yield movement is an excellent indicator.
It is the mortgage-backed market that lenders must pay particularly close attention to when pricing the final rates that they send to the streets. They must make sure that they can price according to where this market demands as well as maintain profitability, while at the same time remaining competitive with other lenders. It is this balancing act with lenders that helps determine what your rate will be.
As discussed in our page on Types of Lenders, individual banks may, however, have an appetite for certain products and intend on keeping that product in their portfolio. For example, a particular bank, for reasons that may vary greatly, may have more of an appetite for adjustable-rate mortgages than for fixed-rate loans or they may prefer jumbo mortgages over conventional loans. These banks will consequently price these loans according to their desire to bring more of this type of loan into their portfolio. If the bank is intending on maintaining a loan type in its portfolio, it may not peg its rate nearly as much as what is happening in the mortgage markets.
Like any business, lenders and banks are in business to make money. Each works within a different profit margin. When a lender is offering rates, it generally is working off a matrix of rates that is offered from the investors that will ultimately purchase the loan. The higher the rate that the lender can deliver to the investor, the higher the premium paid by the investor to the lender, and thus the higher the gross profit will be. The lower the rate, the lower the premium paid from the investor and the lower the profit to the lender. That is why lenders can usually offer lower rates by charging “Discount Points” to the client. These points are so named since they allow the client to obtain a discounted rate by paying points upfront. Each point is equal to 1% of the loan amount and it essentially is a subsidy for the lender for the lost profit from delivering a lower rate to the investor. As with any business, lower profit margins and more efficiently operated businesses can mean better terms for the borrower so make sure to shop around.