RANDOM THOUGHTS: Mortgage Interest Rate Ingredients?

What impacts rates moving up and down?

Author

Todd Ballenger
March 23, 2024

Mortgage Interest Rate Ingredients?

Someone asked the other day how rates are calculated for mortgages… this is a chart created by Aziz that does a nice job of breaking this out, and some thoughts from me are below on what makes these up.

When the FED lowers rates, that has a big impact, but it can be offset (higher or lower) by how their changes impact other areas…

Does the FED raising rates decrease prepayment risk, or increase it, etc.

Also a great article here: What Impacts Rates

  1. Federal Reserve Policy Rates (+2.5%): The largest increase in the mortgage rate is due to the Federal Reserve raising its policy rates. This is typically done to manage economic growth and inflation, and higher policy rates generally lead to higher borrowing costs, including mortgage rates.

  2. Term Premium (+0.8%): This reflects the extra yield that investors require for the risk of holding a longer-term bond, as opposed to short-term bonds. It's compensation for the uncertainty over the life of the investment. An increase in term premiums makes longer-term loans like mortgages more expensive.

  3. Prepayment Risk (+0.8%): Lenders face the risk of mortgage borrowers paying off their loans early, especially if interest rates fall. Lenders charge a higher rate to compensate for this risk.

  4. Inflation (+0.3%): Higher expectations of inflation erode the real returns on loans, so lenders increase rates to maintain their profit margins.

  5. OAS Spread (+0.4%): The Option Adjusted Spread accounts for the difference in yield between a mortgage-backed security and a risk-free bond, adjusted for the option to prepay the mortgage. An increase suggests that mortgage-backed securities have become riskier or less desirable compared to risk-free assets, thus requiring a higher return.

  6. Lender Fees (+0.3%): This could include a variety of lender-specific charges such as origination fees, administrative costs, and points. An increase indicates that the overall costs imposed by lenders have gone up.