The 10 Year U.S. Treasury Bond

If you were to ask most Loan Officers how fixed interest rates are determined, they would answer the 10 year U.S. Treasury bond. This is the most common misconception that most Loan Officers perpetuate because it is repeated so often by other Loan Officers. Here are the facts so you can become more educated than the majority of individuals selling home loans today. 

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 securities investors determine mortgage rates offered to consumers. 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 Rates

The interest rate on a fixed-rate mortgage is fixed for the life of the mortgage. However, on average, fixed-rate mortgages have a lifespan of only about four to seven years. This is because homeowners frequently move or 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 fixed rate mortgages will roughly move with the price of the U.S. Treasury 5 year note or the U.S. Treasury 10 year bond based on a financial principal known as duration. (In practice, a fixed rate mortgage's duration is closer to the 5 year note, but the market tends to use the 10-year bond as a benchmark.) This also means that the interest rate on fixed-rate mortgages offered to consumers should often move up or down with the yield of the U.S. Treasury 10 year bond, although there is not an exact correlation.

So, you can see why there can be confusion for lesser informed Loan Officers. The U.S. Treasury 10 year bond can give an approximation of whether interest rates are rising or falling, but mortgage backed securities are the true determinate of the interest rate you pay on a new fixed rate home loan.

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