Would you believe it if we told you that the biggest determinant of your mortgage rate has nothing to do with your own financial situation? That is a surprise to many who hear about it. But it is true. Here we explain what that factor is and then talk in detail about all the other major factors.
We have been hearing a very common question lately: “The Fed has dropped the mortgage rates to zero. Will my mortgage rate go down as well?” It’s a very obvious question to ask. Mainly because from past experience, people have observed that the two do move together, at least somewhat.
What many may not know is how the two are related and connected. Additionally, people also wonder why their mortgage rate is higher while someone else they know is getting a lower rate, even though both have approximately the same credit scores.
The truth is that there are so many factors that go into how your mortgage rate is calculated that it often becomes complicated for one to understand. Let’s take a closer look and understand how it all works.
Treasury bonds are where it all begins
For those of you who don’t know what a bond is, it’s simply a promise. A promise to return the money that an individual or entity borrows from someone. When that same promise is made by the United States Treasury (which is essentially the government’s ‘bank account’), it is called a ‘Treasury Bond’.
In other words, the Treasury Bond is essentially a promise made by the government to pay you interest in addition to paying back your principal, after you lend the government money for a certain period of time.
How does the government decide how much interest to pay to its bondholders?
The government doesn’t really decide how much interest it’ll pay. It’s the buyers of the bond who decide so. Or investors, as we call them. Just like you don’t decide how much rate you’ll pay on your home loan. Your bank does.
And how do investors come up with that rate? Well, when lending to the US government, default risk isn’t really a big issue. Why? Because the US government has the power to just raise taxes (or print money) and pay back whatever it owes.
The biggest risk investors face is the risk of inflation. If things become expensive over time, they want their money to keep up and grow. In other words, if the price of all goods increases by 2% on an average every year over the next 10 years, they want their money to grow at the same rate. That way, in ten years, they can afford the same things they can buy today with their money.
And how do investors determine how much the rate of inflation will be?
Investors have certain expectations of inflation. And that expectation is typically linked with the rate of economic growth in a country
For countries like the US, Japan and Germany, that are fairly well developed, those rates of economic growth are not that high. Citizens of these countries already own a lot of what they need, to live comfortably. So they don’t end up buying a lot more every year.
On the other hand, for developing countries like China and India, where economies are expected to expand a lot more in the coming years, there is more expectation of growth. A large fraction of the population don’t already own what they need, to have good lifestyles. So there is significantly more scope for economic activity and growth. As a result, rates of inflation in these countries are higher.
Let’s go through one more thing quickly and then get to mortgage rates
The one principle that binds all investment activity is: “The higher the risk, the higher the rate of return that an investor demands”
Why so? Because if an investor gets the same return for two investments with different levels of risk, why would they ever put their money in the more risky investment. Would you, as an investor, ever do that? No. That would be irrational.
The only way investors are willing to put their money into riskier investments is because they expect to make a higher return on those.
This idea not only applies to mortgages, but this is the fundamental idea that drives all of finance, including pricing of stocks, bonds, commodities, or any investment in general.
How does the risk-reward principle come into play when calculating mortgage rates?
Unlike governments, individuals don’t have the power to tax people and/or print money. They have to earn money before they can pay back what they owe to someone else.
And that ability to earn is different for different individuals, based on their skills, education, income, assets liabilities and many other factors. Not only that, that ability can also change over time. People who have a good job today may not continue to have that forever.
As a result, the lender always runs some risk of the individual not being able to pay back the loan in full. If an individual defaults on his loan payment, the lender runs the risk of losing his money.
We are ready to establish the link between government bond rate and your mortgage rate
Say an investor demands a 2% rate to lend money to the government. If he instead lends you that same money for your home, will he still accept a 2% rate? No, of course not. There is a higher risk of you not paying back compared to the government.
By the risk-reward principle, the investor will demand more to lend you the money. Mainly to compensate him for the additional risk he takes by giving his money to you.