We have seen Mortgage rates all over the map recently, both in terms of their movement and in their variation between lenders. It’s been common to be seeing rates that are half a point lower than they were just last week and a full point below the mid-June highs.
While is an exceptionally fast drop, even more interesting (and uncommon) is the fact that mortgage rates have dropped faster than US Treasury yields. It’s typically the other way around as investors flock first to the most basic, risk-free bonds.
Like many, you may be wondering why mortgages are winning the race this time? The most notable factor is the structure of the underlying mortgage bond market. Sounds confusing right? Keep reading as the steps below hopefully will clarify some things.
Step 1: Mortgage rates are based primarily on mortgage-backed securities or MBS. As lenders originate (issue) mortgages, those mortgages can be “turned into” MBS. Once that happens, they’re then sold to investors who want to earn interest on mortgage debt.
Step 2: MBS have a coupon–which is the official rate paid out by a bond. Other bonds, like the 10yr Treasury Note, also have coupons.
Step 3: MBS have a price. Same story for a 10yr Treasury note. This is the price an investor pays to own $100 of that bond, but can be higher or lower than $100. For example, if an investor pays more than $100 for a bond with a hypothetical coupon of 4%, they are technically earning less than a 4% rate of return because they paid more upfront. Coupons are periodically set in stone and the bond market moves by changing the price it pays for that coupon. The combination of price and coupon allows those investors to know the actual yield associated with a bond. So when you see 10yr yields moving all over the place every day, the coupon never changed. Just the price.
Step 4: Unlike Treasuries, which change coupons only one per quarter, MBS coupons are offered in half point increments (i.e. 4.0, 4.5, 5.0, etc) and they are constantly available for investors to buy and sell.
Step 5: In other words, investors have CHOICES TO MAKE when it comes to which MBS to buy. Investor demand for any given coupon can undergo alternate increases and decreases for multiple reasons. Generally speaking, when investors think the broader rate market has topped out or that rates will continue to move lower, they prefer to buy the lowest MBS coupons possible.
Step 6: Mortgage lenders have choices to make when it comes to choosing an MBS coupon to place their recently originated loans into. There are boundaries here. Any given MBS coupon is limited to mortgage rates that are between 0.25% and 1.125% above that coupon. For example, a 4.0 coupon MBS is like a bucket that can only hold mortgages with rates of 4.25% through 5.125%.
The distance between adjacent MBS coupons grew so small that it didn’t take as much of a bond market improvement as it would normally take for lenders to make the jump down to the rates associated with the lower coupon. In some cases, advertised rates may indeed involve some upfront points, like when you see ultra low rates advertised online. That’s because it may only take a fraction of a point to bring the rate into the next lower MBS coupon bucket. In other words, points have a lot of bang for their buck right now. That doesn’t mean it’s the best option (after all, if rates keep falling, you’re going to wish you didn’t pay any upfront points)–just a phenomenon that helps us reconcile big changes in mortgage rate headlines and indices.
If you’re intersted in knowing more and chatting with a trusted lender who won’t play games, let’s connect!