How Are Mortgage Rates Tied to Bonds?

From an investor standpoint, a mortgage is a fixed-income investment that provides regular interest income. The interest rate competes with those of other fixed-income investments, mostly bonds of similar risk and maturity. How mortgage rates are specifically tied to bonds depends on the type of mortgage and what happens after it is originated.

Securitization

• Most mortgages are securitized -- sold to a government entity such as the Government National Mortgage Association or a Wall Street investment bank that carves and repackages them into various types of bonds, such as GNMA bonds or collateralized mortgage obligations, that are then sold to investors. The rate on those bonds is set by the market as a middle ground between what borrowers are willing and able to pay and what investors will accept for the risk.

Mortgages Kept on the Books

• Some banks and lenders keep mortgages they originate on the books, meaning they do not sell them. Their goal is to provide the highest return to their shareholders in the form of a difference between the interest they pay on deposits and the interest they collect on mortgages. The returns must be comparable to the returns that banks can generate by buying and holding other types of bonds, for example U.S. government bonds, with depositors' money.

Variable Rate Mortgages

• Variable-rate mortgages are set by adding a fixed margin to a recognized interest rate or bond index, such as the prime rate or the London interbank offering rate, so variable-mortgage rates are always tied to prevailing short-term bond interest rates. The only difference is annual and lifetime interest rate caps that some variable-rate mortgages may contain.

Supply and Demand

• Mortgage rates are affected by supply and demand. If the real estate market is hot and the demand for mortgages is high while the available supply of money is tight, mortgage rates can be higher than the interest rate on other types of bonds. If the real estate market is slow and mortgage demand is low, mortgage rates may be low as there is excess cash looking for a return wherever it can find it, so investors are willing to accept less income on mortgages.

Perceived Risk

• Investor attitude toward mortgage risk also varies. When real estate values are rising, mortgages are perceived to have less risk, so mortgage rates may be lower compared with other types of bonds. When real estate values are falling and borrowers are defaulting or walking out on mortgages, investors demand extra compensation for risk so mortgage rates can be higher.