How mortgages rates are determined...

I wanted to follow up to clarify some things pertaining to my last blog and answer some questions that were asked about the way mortgage rates work.   

In response to my last blog I had gotten some questions regarding the nature of mortgage rates and why the margin on rates has adjusted considerably compared to the banks Prime Lending Rate over the last few years.  The questions were good ones and also demonstrate a common misconception of the public that mortgage rates are tied to the Prime Lending rate of the bank.  This is not the case.  

When a mortgage is originated, the note that is signed at closing (or obligation for repayment) is bundled with other like notes and sold off in the secondary market.  This is known as a mortgage backed security.  Essentially, investors pay a premium up front for the privilege of having a rate of return on their investment over time.  This mortgage backed security is traded, like any other investment, on Wall Street.  There is a market for mortgage backs since some investors may be willing to pay a higher premium than others for the same rate of interest return over time.   Most banks are not funding these loans themselves, but selling the funding off to the highest bidder. 

From an investors perspective, this security represents a rate of return with some degree of risk involved.  Since the basis for all rates of return on wall street are US Treasuries (guaranteed by the US government), this "risk" based security needs to demonstrate a higher return than the T-bill.  The spread between the rate of returns of mortgage backs and T-bills has widened, as I expressed in my previous blog, since there is now a higher perceived risk in mortgages than there has historically been.   

The prime lending rate on the other hand is what is effected by the Fed when it moves rates.  If we get a 1/4 point drop in the Fed Funds or discount rate (the two rates the Fed controls that effect the rate at which banks borrow money), the banks will pass that drop onto there clients by lowering their prime rate 1/4%.  Generally, any loans that the bank will be funding directly, such as home equity lines of credit, credit cards, personal and business loans, will be tied to the banks prime lending rate.   Since first mortgages are generally not funded directly by the bank they are not tied to prime.  

I hope that this explanation helps.  Please let me know if I can be of further assistance and have a very Happy Thanksgiving!