The 10-year Treasury rate has moved over the 1 percent mark in recent weeks for the first time since the pandemic began. Should we expect higher mortgage rates as well?
In normal times, that’s the usual pattern because the two rates are closely tied. But, the traditional rules might not apply this time around. Mortgage rates could go lower or stay at record lows in 2021 even as Treasury rates increase. Here’s why.
How mortgage rates are set
The federal government is the biggest debtor in the world. The money it takes in from taxes and tariffs isn’t close to what the government spends, with the deficit expanding over 60 percent this fiscal year alone. The result is that the government borrows heavily. According to the Peter G. Peterson Foundation, the national debt now tops $27.7 trillion.
To finance the debt, the U.S. issues Treasuries maturing in various terms, such as the 10-year Treasury. This is the instrument that mostly closely tracks fixed long-term mortgage rates.
Find it odd that pricing for 10-year Treasury notes and 30-year fixed-rate mortgage financing tend to follow a similar path, despite the different terms involved? In practice, few mortgages remain outstanding for 30 years or anything close, so for investors, the 10-year Treasury serves as a benchmark rate for mortgage purchases.
Treasury rates vs. mortgage rates
Mortgage rates generally rise and fall with 10-year Treasurys, but that’s not always the case. Sometimes the two rates go in different directions, or one moves more dramatically in one direction than another. In the summer of 2020, we saw an example of this.
“The 30-year mortgage rate generally follows long-term Treasury yields, but the difference, or spread, is not constant,” said William R. Emmons, an assistant vice president and economist at the Federal Reserve Bank of St. Louis.
From the start of 2020 to mid-2020, for instance, the 10-year Treasury yield declined by 1.2 percentage points, but the mortgage rate has declined by less than 0.6 percentage points. One reason is that lenders, faced with a deluge of mortgage applications, increased their spread (profit margin) to both fatten their coffers and discourage even more business many didn’t have the capacity to fill.
Fatter profits mean more room to cut rates
As it happens, 2020 was very good to mortgage lenders. Borrowers lined up to finance and refinance at record-low rates, and the results showed up on lender bottom lines. According to the Mortgage Bankers Association (MBA), the typical lender had a production profit of $5,535 per loan in the third quarter of last year, up substantially from the $1,924 earned during the same period in 2019.
“With the surge in mortgage production volume in the third quarter, net production profits among independent mortgage bankers increased, surpassing 200 basis points for the first time since the inception of MBA’s report in 2008,” said Marina Walsh, MBA’s vice president of industry analysis.
Black Knight estimated in November that 2020 mortgage originations would top $4 trillion.
But what happens in 2021 if Treasury interest levels rise but mortgage demand declines? Given that 2020 was such a historically strong year for mortgages, even a moderately good 2021 can lead to fewer originations.
No doubt lenders want to maintain their profit margins, but that may not be possible as many lenders seek to keep the pipeline full after investing in increased staffing and resources to handle more loans.
“Production expenses usually drop with increased volume as fixed costs are spread over more loans,” according to the Mortgage Bankers Association. “However, in Q3, costs rose despite increasing volume. One major reason for this increase was escalating personnel costs, including signing bonuses, incentives, overtime and commissions that were pushed higher with the need and competition for workforce talent. Those pressures will likely persist in the short-term.”
So if origination activity declines, so can mortgage rates because 2020 profits per loan were outsized. To stay competitive and control fixed costs per loan at least some lenders may offer lower rates even if Treasury levels rise.
If you’re thinking about a refi in 2021
Shelby McDaniels, channel director for corporate home lending at Chase Home Lending, offers a few scenarios where you could benefit from current market rates:
- When it lowers your monthly rate and/or payment.
- If you can reduce loan term/remaining payments with minimal increase in monthly payment.
- If you can use debt consolidation from the refi to lower overall monthly obligations.
- Using a cash-out refi for home improvements or some other major purchase.