Why rates should be even lower...

Good afternoon…

Everyone who owns a home or is in the market for one knows that rates are at record lows. What they might not know is that there are a couple factors prohibiting them from declining further.

Basically, banks lend their money at a lower interest rate then what they charge the customer. This is called arbitrage and it’s a cornerstone of banks’ operating procedure. It’s an age-old process that will never cease. We, as consumers, are used to it, whether we understand it or not.

With that being said, we have seen unprecedented mortgage interest rate levels as well as home affordability levels over the last couple of years. And it looks as if this trend will continue for the forseeable future. The Federal Reserve has been greatly involved in trying to stimulate the economy, with the housing industry as one of their main focal points. Through a couple rounds of bond buying (QE 1 and QE 2) they’ve helped lower rates by buying trillions of bonds. Just week, they agreed to purchase another $40 billion worth of mortgage-backed securities.

To anyone in the housing industry, this is old news already, right? So why aren’t rates falling even further? We’ve noticed a slight decline overall, but for the most part, rates have not gotten substantially better despite this positive step forward by the Fed. Over the last few years, the spread between the bond rate and mortgage rates has been about .75%, which means the banks are profiting about that much on each deal. With bond prices where they are, and yields at all-time lows, the spread has grown dramatically, close to 1.5%. This is because bond yields have fallen a lot faster than the rates banks are offering consumers on mortgages. In other words, banks are taking bigger gains and increasing profits instead of passing lower rates on to us.

Are you surprised?

Other factors come into play: most banks would not be able to handle the volume if the profit margin was lowered to it’s average level of .75%. That would make the 30 year fixed under 3%! With interest rates where they’re at, more volume will be generated. The banks will add more origination capacity, but probably not enough to lower the spread. Since the revenue from mortgages is very, very strong right now, there’s no reason to lower it.

So we’re left with phenomenal rates, but we’re left out of extraordinary ones. And so it goes…

Have a great weekend everyone.