The Elusive Mortgage Rate Formula – Demystified Right Here!

The factors that increase and decrease mortgage rates are extremely complex, and lead many people to make assumptions about them that are not true. As someone who works with many mortgage brokers and has done a lot of in-depth research on this topic, I am shocked to hear the many wild theories about what affects mortgage rates. Even some mortgage brokers make incorrect assumptions.

Below, I will first explain how mortgage rates are actually determined, and debunk the myth that they are set directly by the Federal Reserve.

Mortgage interest rates are based on one thing: the mortgage backed securities market. This market is controlled by banks and mortgage lenders. These entities bundle their mortgage loans together and sell them as investments called mortgage backed securities (MBS). These MBS are then traded as bonds by investors, and the price of these bonds has an inverse relationship with mortgage rates. That is, the higher the price of mortgage backed securities, the lower mortgage rates go.

The volume of trade in these MBS is the only true factor that influences mortgage rates. Like all other bonds prices, mortgage backed security trading volume moves based on news about the economy, trading, and any other factors that make investors more or less confident about their long-term financial prospects in America.

This brings us to the first myth about rates-that they are set by the Federal Reserve. This is simply not true. The Federal Reserve has a minor impact on mortgage interest rates that is neither direct nor immediate. The fed can sometimes indirectly affect mortgage rates by announcing changes to interest rates. Interest rate changes affect home equity loan rates, credit card interest rates, money market account activity, and activity on certificates of deposit. In particular, when the fed reduces interest rates, investors sell money markets and CDs to free up cash for into stocks and bonds. In turn, when people buy more bonds, bond prices rise. Remember, mortgage backed securities are just another type of bond. The more MBS investors buy, the higher the price on the bonds rises. This in turn lowers rates. 

The rules above apply particularly to long-term mortgage interest rates, such as 30 year fixed rates. Short term mortgages, such as 5 year ARMs and 7 year ARMs, are affected by different factors and do not necessarily follow the same rules.