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Mortgage Interest Rates - How Are They Determined?

Published by Lawrence Roberts | December 26th 2008 | Views:

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Mortgage interest rates are the single-most important factor determining the borrowing power of a potential house buyer. When rates are very low, a borrower can service a large amount of debt with a relatively small payment, and when interest rates are very high, a borrower can service a small amount of debt with a relatively large payment.

Mortgage interest rates are determined by market forces where investors in mortgages and mortgage-backed securities bid for these assets. The rate of return demanded by these investors determines the interest rate the originating lender will have to charge in order to sell the loan in the secondary market. Some lenders still hold mortgages in their own investment portfolio, but these mortgages and mortgage rates are subject to the same supply and demand pressures generated by the secondary mortgage market.

Mortgage interest rates are determined by investor demands for risk adjusted return on their investment. The return investors demand is determined by three primary factors: the riskless rate of return, the inflation premium and the risk premium.

The riskless rate of return is the return an investor could obtain in an investment like a short-term Treasury Bill. Treasury Bills range in duration from a few days to as long as 26 weeks. Due to their short duration, Treasury Bills contain little if any allowance for inflation. A close approximation to this rate is the Federal Funds Rate fixed-rate mortgages are paid off before the 30 year maturity with 7 years being a typical payoff timeframe.

The difference in yield between a 10-year Treasury Note and a 30-day Treasury Bill is a measure of investor expectation of inflation, and the difference between the yield on a 10-year Treasury Note and the prevailing market mortgage interest rate is a measure of the risk premium.

Inflation reduces the buying power of money over time, and if investors must wait a long period of time to be repaid, as is the case in a home mortgage, they will be receiving dollars that have less value than the ones they provided when the loan was originated. Investors demand compensation to offset the corrosive effect of inflation. This is the inflation premium.

The risk premium is the added interest investors demand to compensate them for the possibility the investment may not perform as planned. Investors know exactly how much they will get if they invest in Treasury Notes, but they do not know exactly what they will get back if they invest in residential home mortgages or the investment vehicles created from them. This uncertainty of return causes them to ask for a rate higher than that of Treasury Notes. This additional compensation is the risk premium.

Thus, mortgage interest rates are a combination of the riskless rate of return, the risk premium and the inflation premium.
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