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  Dear
Dr. Don,
I am confused. What does the bond market have to do with mortgage
rates?
-- Kristi Credit
 Dear
Kristi,
The bond market and the mortgage market are linked in several important
ways. A cost of funds approach is an easy explanation for why the
markets are linked. Mortgage lenders borrow funds to provide homeowners
with the money at closing to buy a home. As a lender's cost of funds
increases, they have to pass along those increases in the form of
higher mortgage rates. Conversely, as their cost of funds decline
they can reduce mortgage rates to reflect the reduced costs.
The cost of funds link is easiest to understand
with a home equity line of credit (HELOC) example. If a lender's cost
of funds approximates the targeted federal funds rate, then every
quarter point increase in the targeted federal funds rate increases
the bank's interest expense. The prime rate typically will move in
tandem with the change in the federal funds rate. The recent increase
in fed funds from 2.5 percent to 2.75 percent saw a corresponding
increase in the prime rate from 5.5 percent to 5.75 percent. A HELOC
based on the prime rate would adjust with the change in prime, subject
to any limitations on interest rate resets in the mortgage agreement.
A second tie is risk based. Here let's talk about
the ties between the bond market and the mortgage market for a standard
30-year fixed rate mortgage. Lenders need to be compensated for
the risk that they take on when lending money. The market for U.S.
Treasury securities is considered to be free of default risk. Interest
rates will fluctuate over time with general economic conditions,
but if you buy a U.S Treasury bill, note or bond, you'll get the
face value of that bond when the bond matures.
Homeowners, regardless of their credit rating, aren't
as reliable as the U.S. government in repaying their debt. Lenders
are going to price that risk into the mortgage rate. The lender
could choose to invest in Treasury securities rather than mortgages.
For the lender to choose mortgages instead it has to be compensated
for that additional risk.
The interest rates for 30-year fixed rate mortgages
are highly correlated to the interest rate on the 10-year Treasury
note. That link was true even when the U.S. Treasury issued 30-year
Treasury bonds. Homeowners may get a 30-year fixed-rate mortgage
but they don't typically keep the mortgage for 30 years. Refinancings,
home sales or additional principal payments reduce the average life
of a 30-year mortgage closer to the 10-year mark.
Lenders have to be compensated for the risk
they take and be able to earn a return that compensates them for
their costs, including the cost of funds. Changing interest rates
in the bond market have an effect in the mortgage market.
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