Mortgages come in two primary forms, fixed rate and adjustable rate, with some hybrid combinations and multiple derivatives of each. A basic understanding of interest rates and the economic influences that determine the future course of interest rates can help consumers make financially sound mortgage decisions, such as making the choice between a fixed-rate mortgage or adjustable-rate mortgage (ARM) or deciding whether to refinance out of an adjustable-rate mortgage.

In this article, we'll discuss the influence of interest rates on the mortgage industry, and how both will ultimately affect the amount you pay for your home.

The Mortgage Production Line
The mortgage industry has three primary parts or businesses: the mortgage originator, the aggregator and the investor.

The mortgage originator is the lender. Lenders come in several forms, from credit unions and banks to mortgage brokers. Mortgage originators introduce and market loans to consumers. They sell loans. They compete with each other based on the interest rates, fees and service levels that they offer to consumers. The interest rates and fees they charge consumers determine their profit margins. Most mortgage originators do not portfolio loans (they do not retain the loan asset). Instead, they sell the mortgage into the secondary mortgage market. The interest rates that they charge consumers are determined by their profit margins and the price at which they can sell the mortgage into the secondary mortgage market.

The aggregator buys newly originated mortgages from other institutions. They are part of the secondary mortgage market. Most aggregators are also mortgage originators. Aggregators pool many similar mortgages together to form mortgage-backed securities (MBS) - a process known as securitization. A mortgage-backed security is a bond backed by an underlying pool of mortgages. Mortgage-backed securities are sold to investors. The price at which mortgage-backed securities can be sold to investors determines the price that aggregators will pay for newly originated mortgages from other lenders and the interest rates that they offer to consumers for their own mortgage originations.

There are many investors in mortgage-backed securities: pension funds, mutual funds, banks, hedge funds, foreign governments, insurance companies, and Freddie Mac and Fannie Mae (government-sponsored enterprises). Since investors try to maximize returns, they frequently run relative value analyses between mortgage-backed securities and other fixed income investments such as corporate bonds. As with all financial securities, investor demand for mortgage-backed securities determines the price they will pay for these securities.

Do Investors Determine Mortgage Rates?
To a large degree, mortgage-backed security investors determine mortgage rates offered to consumers. As explained above, the mortgage production line ends in the form of a mortgage-backed security purchased by an investor. The free market determines the market clearing prices investors will pay for mortgage-backed securities. These prices feed back through the mortgage industry to determine the interest rates offered to consumers.

Fixed Interest Rate Mortgages
The interest rate on a fixed-rate mortgage is fixed for the life of the mortgage. However, on average, 30-year fixed-rate mortgages have a lifespan of only about seven years. This is because homeowners frequently move or will refinance their mortgages.

Mortgage-backed security prices are highly correlated with the prices of U.S. Treasury bonds. This means the price of a mortgage-backed security backed by 30-year mortgages will move with the price of the U.S. Treasury five-year note or the U.S. Treasury 10-year bond based on a financial principal known as duration. In practice, a 30-year mortgage's duration is closer to the five-year note, but the market tends to use the 10-year bond as a benchmark. This also means that the interest rate on 30-year fixed-rate mortgages offered to consumers should move up or down with the yield of the U.S. Treasury 10-year bond. A bond's yield is a function of its coupon rate and price.

Economic expectations determine the price and yield of U.S. Treasury bonds. A bond's worst enemy is inflation. Inflation erodes the value of future bond payments - both coupon payments and the repayment of principle. Therefore, when inflation is high, or expected to rise, bond prices fall, which means their yields rise - there is an inverse relationship between a bond's price and its yield.

The Fed's Role
The Federal Reserve plays a large role in inflation expectations. This is because the bond market's perception of how well the Federal Reserve is controlling inflation through the administration of short-term interest rates determines longer-term interest rates, such as the yield of the U.S. Treasury 10-year bond. In other words, the Federal Reserve sets current short-term interest rates, which the market interprets to determine long-term interest rates such as the yield on the U.S. Treasury 10-year bond.

Remember, the interest rates on 30-year mortgages are highly correlated with the yield of the U.S. Treasury 10-year bond. If you're trying to forecast what 30-year fixed-rate mortgage interest rates will do in the future, watch and understand the yield on the U.S. Treasury 10-year bond (or the five-year note), and follow what the market is saying about Federal Reserve monetary policy.

Adjustable-Rate Mortgages
The interest rate on an adjustable rate mortgage might change monthly, every six months or annually, depending on the terms of the mortgage. The interest rate consists of an index value plus a margin. This is known as the fully indexed interest rate. It is usually rounded to one-eighth of a percentage point. The index value is variable, while the margin is fixed for the life of the mortgage. For example, if the current index value is 6.83% and the margin is 3%, rounding to the nearest eighth of a percentage point would make the fully indexed interest rate 9.83%. If the index dropped to 6.1%, the fully indexed interest rate would be 9.1%.

The interest rate on an adjustable-rate mortgage is tied to an index. There are several different mortgage indexes used for different adjustable-rate mortgages, each of which is constructed using the interest rates on either a type of actively traded financial security, a type of bank loan or a type of bank deposit. All of the different mortgage indexes are broadly correlated with each other. In other words, they move in the same direction, up or down, as economic conditions change. Most mortgage indexes are considered short-term indexes. "Short-term" or "term" refers to the term of the securities, loans or deposits used to construct the index. Typically, any security, loan or deposit that has a term of one year or less is considered short term.

Most short-term interest rates, including those used to construct mortgage indexes, are closely correlated with an interest rate known as the Federal Funds Rate.

Forecasting Changes
If you're trying to forecast interest rate changes on adjustable rate mortgages, look at the shape of the yield curve. The yield curve represents the yields on U.S. Treasury bonds with maturities from three months to 30 years. When the shape of the curve is flat or downward sloping, it means that the market expects the Federal Reserve to keep short-term interest rates steady or move them lower. When the shape of the curve is upward sloping, the market expects the Federal Reserve to move short-term interest rates higher. The steepness of the curve in either direction is an indication of by how much the market expects the Federal Reserve to raise or lower short-term interest rates. The price of Fed Funds futures is also an indication of market expectations for future short-term interest rates.

Concluding Tips
An understanding of what influences current and future fixed- and adjustable-rate mortgage rates can help you make financially sound mortgage decisions. This knowledge can help you make a decision about choosing an adjustable-rate mortgage over a fixed-rate mortgage and can help you decide when it makes sense to refinance out of an adjustable rate mortgage. Below are a few final tips.
Don't believe everything you hear on TV. It's not always "a good time to refinance out of your adjustable-rate mortgage before the interest rate rises further." Interest rates might rise further moving forward. Find out what the yield curve is saying.

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