How Does Mortgage Bond Trading Affect Rates?

Banks sell loans to firms such as Freddie Mac.

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A home mortgage contract is a simple lending agreement between a creditor and a borrower. But the interest rate charged for such a mortgage is subject to market forces, because most home loans are sold by banks to investors. Consequently, trading activity affects mortgage rates, although U.S. Treasury bonds also play a role.

Determining Mortgage Interest Rates

In the investment market, mortgages are categorized alongside bonds as debt instruments. Investors seeking income can buy individual debt securities or acquire shares in mutual funds that contain thousands of mortgages or bonds. Credit rating agencies regard the U.S. government as one of the world's most creditworthy borrowers. Consequently, Treasury bonds set the benchmark for other debt securities. The average home loan is paid off or refinanced within 10 years. Therefore, the average yield on 10-year federal Treasuries is used as a rough barometer for setting 30-year mortgage rates. The margin between 10-year Treasuries and mortgages fluctuates over time, but rates on fixed 30-year mortgages always exceed rates being paid on Treasuries.

Credit Score

As a consumer, you have a particular risk profile because your income level and expenses differ from those of your friends and neighbors. Your credit history, your home's value and your current income level can all have an effect on your creditworthiness. Low-risk borrowers have access to mortgages with rates closest to the yield available on 10-year Treasuries. People with poor credit usually have to pay much higher rates on home loans. Banks sell mortgages to investment firms, such as federally chartered home guarantor Freddie Mac, that convert loans into marketable securities. In turn, these firms package similarly priced loans into mutual funds and sell shares in these funds to investors.

Supply and Demand

As with any investment, mortgage trading is heavily affected by the forces of supply and demand. In a strong economy, inflation causes prices to rise, and mortgages with high interest rates become attractive to investors seeking income. Foreclosure rates tend to dwindle when the economy is growing, so investors are more willing to contend with the risks associated with high-rate loans. In contrast, low-risk loans become popular during tough economic times, because investors are wary of losing money on high-risk loans. If the demand for low-risk loans outstrips the supply, banks begin to hike up rates to maximize their earnings. Banks have to ensure that rates are low enough to entice borrowers but high enough to attract investors.

Secondary Market Trading

High foreclosure rates can cause mortgage-backed securities to plummet in value. In such instances, mortgage bond owners often sell their holdings at a discount to other investors on the secondary market. In a booming economy, mortgage investors often cash in by selling debt securities for profit. Trading on the secondary market doesn't necessarily have a direct impact on mortgage rates, because the trading does not involve banks or firms that package loans. However, this trading can have an indirect impact as banks attempting to sell new loans have to compete with investors selling previously issued securities.