Mortgage rates change daily, and sometimes multiple times per day. In this article, “mortgage rates” will refer to the combination of upfront cost and actual interest rate described here: The 2 Components of Mortgage Rates. For example, if we talk about “higher rates,” it could either mean that the interest rate is higher, or simply that the upfront cost is higher for the same interest rate.

These frequent changes are not arbitrary in any way. Instead they are the result of multiple factors with varying levels of importance and interdependence. Mortgages exist because investors want to earn interest by offering loans. Because of this, mortgage rates end up being directly driven by all the various market forces and operational considerations that dictate what those investors can/should/must charge.

Factors relating to market forces

Much like mortgage borrowers need money to buy a home, the US government needs money to finance Federal spending. Political commentary aside, this creates a massive market for government debt, which in turn serves as the plainest, most risk-free benchmark for many other types of debt. Collectively, this is known as “the bond market.”

There are many other types of bonds with varying levels of risk and different features. They all exist because investors need or want to lend money and various entities need or wants to borrow money and. Mortgage borrowers are one such entity. When lenders have enough of the same type of loan from mortgage borrowers with similar circumstances, those loans can be grouped together to form a bond that can then be sold to other investors. Once the mortgage lender sells those loans to other investors, they now have the cash flow to go make news loans—assuming there are other investors who are interested in buying more loans.

Thus, a market for these mortgage-backed-securities (MBS) is born. It’s quite a bit more complex in practice, but generally speaking, it’s simply a market for groups of loans. These trade on the open market and tend to follow the broader movements of more mainstream bonds like US Treasuries. In short, all the factors that can affect interest rates in the bond market can also affect the price that investors are willing to pay for these groups of mortgages. Those prices have a more direct influence on the rates that mortgage lenders can offer than anything else!

Bottom line: loans become mortgage-backed-securities which trade on the open market, and the prices of mortgage-backed-securities dictate the rates that lenders can offer to new mortgage borrowers.

Factors relating to operational considerations

Knowing the price that investors are willing to pay for a group of similar mortgages gives lenders a baseline for the costs they must charge borrowers. The lender’s operational considerations will account for the rest. These considerations are all directly or indirectly related to how much profit the lender wants to make or how much business they are capable of doing.

For instance, we tend to think of banks as always being available to make loans to borrowers who fit the right criteria, but that isn’t always the case. Many mortgage lenders have a certain amount of cash flow that they’d ideally like to use over a certain time frame. If a lender isn’t on pace to lend as much as they’d like, they might lower rates in order to entice more business. Conversely, if a lender is on pace to lend out more money than it has, it could raise rates in order to deter business.

Apart from the availability of funding, lenders must also consider the availability of personnel. It takes human beings to make loans happen, and at a certain point, a lender will be at capacity. It can then either hire more staff or simply raise rates to throttle the amount of incoming business.

These are two of the most basic operational considerations for lenders that complement the actual market-driven prices of mortgages. This can be thought of as any sort of business that sells a product made from raw materials. A car company, for example, is greatly affected by the cost of steel and aluminum, but the cost that buyers end up paying is also greatly affected by how that car company does business. How many factories do they have? How well-trained are their employees? How efficient are they?

In the mortgage world, mortgage-backed-securities would be like the steel and aluminum while individual lenders would be like auto manufacturers, each trying to build/sell cars as efficiently and as profitably as possible.

Bringing it all together

The lender-specific considerations certainly change and certainly account for a portion of any given mortgage rate offering. Quite simply, this is why different lenders offer loans at different rates even though they’re all working with the same raw materials.

But it’s those raw materials—those mortgage-backed-securities—that move throughout the day and do most to affect the moment-to-moment changes in lenders’ rate sheets. If something in the world is happening to cause investor demand to increase in bond markets, MBS tend to benefit as well. When MBS prices rise, investors are willing to pay more for those bundles of loans, meaning that lenders may be able to offer lower rates. Conversely, if investors are seeking riskier investments for whatever reason, MBS prices could fall, meaning investors aren’t paying as much for mortgages, thus forcing lenders to raise rates.

Mortgage rates, for the purposes of this article, will refer to the most commonly-quoted loans available through the most prevalent channels. That essentially means conforming, fixed rate loans—especially 30yr and 15yr fixed. It’s not that other loan types aren’t affected by the same variables, just that the most prevalent loans will be affected more reliably.

An example of one of these mainstream rate quotes would be a 30yr fixed from a big bank or mortgage lender a retail branch of that bank or indirectly via a mortgage originator who has access to several correspondent or brokered banking channels. In both cases we’re talking about some large underlying financial entity that is in the business of making lots of loans.

These sorts of lenders will typically adjust their rate sheet offerings every day. In fact, it’s extremely rare to see absolutely no change in any given lender’s rate sheet from one day to the next. That said, it’s also rare for rates to change so much that the actual contract interest rate is affected. That’s because rates are almost universally quoted in .125% increments. As such, rates would have to change by .125% in order for a rate that had been quoted at 4.0% to now be quoted at 4.125%, all other things being equal. And it’s rare to see that much movement in a single day.

The “fine-tuning adjustment” for mortgage rates lies in the upfront cost side of the equation. This can either be an actual cost out of the borrower’s pocket (“discount points”), or a rebate from the lender. Rebates to cover closing costs, etc., are a common feature of loan quotes, and lenders are able to offer them because of the interest collected over time. The higher the rate, the higher the potential rebate. The lower the rate, the higher the cost. For example, if a 4% rate involved neither an upfront discount nor a rebate from the lender, then a 3.875% might require a 1.0% discount point and a 4.125% might result in a 1% rebate from the lender.

In that example the discount point and the rebate are both part of the same component of “mortgage rates.” One is negative and the other is positive, but they both represent the COST side of the equation. This is the side of the mortgage rate equation that is almost guaranteed to be changing every day—sometimes multiple times per day, and those changes can be extrapolated to changes in effective rate. In other words, an effective rate of 4.04 doesn't mean that people are being quoted 4.04. Rather, the actual rate quotes are mostly likely 4.0% with an upfront cost or 4.125% with a rebate.

At some point during the mortgage process, the contract interest rate (the one that ends up on the Promissory Note--the most official document stipulating the terms of repayment) must be “locked.” This means that there is an agreement between the borrower and the lender regarding what the contract rate will be. The rate-lock will also specify a date by which the mortgage must be closed and funded.

Lock Time Frames

Rate lock time frames can vary. Historically, the most common time frame had been 30 days. The regulatory changes of the post-meltdown era caused slightly longer turn-times for the various steps in the mortgage process, resulting in an increased prevalence of 45 and 60-day lock times. There continue to be shorter and longer lock time frames as well, depending on the lender. These include, but are not limited to 10, 15, 21, and 90 days.

In some scenarios, or among certain lenders, the borrower doesn’t have any input as to when and for how long the rate will be locked. The borrower may either agree to the lender’s lock policy or take their business elsewhere. In most cases, however, there is a certain degree of liberty when it comes to choosing “when” and “for how long” to lock. In these cases, mortgage originators will help manage expectations as to how quickly the process can be completed, with the generally understood goal being to set a lock window that leaves plenty of time for the loan to fund, but that also isn’t unnecessarily long.

Cost Considerations

Why wouldn’t we want a lock time-frame that’s unnecessarily long? Bottom line: the longer the lock window, the higher the cost. When it comes to the mortgage process, costs associated with your rate can take the form of changes to the rate itself or changes to the upfront cost (discount or rebate) associated with that rate. Locking the same rate for longer means that the discount cost will be higher or the rebate will be lower. The relationship between days of lock time and cost isn’t always exactly linear, so it can make sense to weigh the risk and reward of various time frames.

When to lock

There’s no universally correct answer to the question: “should I lock or float.” It’s one of the most thought-provoking and complex topics in the world of mortgage origination. There are too many variables for one methodology to be applicable to every scenario. It goes without saying that locking as early in the process as possible will always be the safest option for the borrower. It’s also unequivocally true that it’s historically the least profitable option on the average day from 1980 on. That said, this is only the case because interest rates have generally been moving lower since 1980! Not only that, but there have also been many times since 1980 where rates have risen brutally, in spite of the longer-term trend. In many of those cases, borrowers that failed to lock early enough in the process were either forced to accept a higher rate or simply never completed the process.

Purchase and Refi Lock Considerations

When we talk about “never completing the process,” this could naturally be a very big problem in some cases. For example, rates can rise quickly enough that many borrowers can no longer qualify for the monthly payment. If they’re not locked, they simply cannot complete the mortgage. In the case of purchases, that could mean they just lost their earnest money deposit--not to mention the opportunity to buy the house they wanted or needed. Even in the case of refinances, failing to complete the mortgage can mean the loss of significant monthly savings or in more dire cases, much-needed cash for any number of purposes.

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Because of these potential pitfalls, it’s almost universally wise to heavily consider locking as soon as the monthly payment and lock time frame make sense for your scenario, and to only forego locking if you’re prepared for the increased costs associated with an unforeseen rise in rates. If such a rate rise would jeopardize your qualification for the mortgage or even your willingness to complete it, locking is the only option.

Lock Extensions and Expirations

Despite the best intentions and diligent participation among all parties, some mortgage are destined to run past their initial lock time frame. While there is no universal policy, most lenders are able to extend the lock time frame based on certain conditions. Most of the time, this will involve a predetermined cost, and in many cases, this is simply the difference in cost between your original lock time frame and the next tier. For example, if there was a 0.125% change in the discount points in order to lock for 60 days instead of 45, and assuming you locked for 45 days only to find it wasn’t going to be long enough near the end of the process, extending to the 60 day lock could be as simple as adding the 0.125% to your upfront costs in order to extend the lock for 15 days.

In other cases and depending on the lender, the situation can be far more severe--especially if rates have moved significantly higher since you first locked. It can absolutely be the case that going over the originally-agreed-upon lock time frame means that your loan will now have “worst-case” pricing. This means that you have to pay whichever is higher between the original cost of the lock time frame needed to complete the loan or the current market rate. If we’re only talking about something like the 0.125% from the previous example, that’s not a big deal, but if rates had moved significantly higher, that cost increase could easily be over 1.0%--enough to make anyone wish they’d chosen the longer lock window upfront.

Many mortgage industry professionals and a vast majority of consumers are not familiar with Mortgage-Backed Securities (MBS), let alone the critical role they play in mortgage rate movements. Those with a basic understanding of that relationship will have a much clearer picture of the mortgage process.

What is MBS? Securitization?

MBS or “Mortgage-Backed Securities” are what groups of similar loans turn into in order to be sold, bought, and traded. This process of turning loans into securities is known as “securitization.”

Securitization, though not without its risks, is largely beneficial for all parties involved, and is currently essential to maintaining availability of mortgage credit (ability of consumers to get a loan if they want one). It also helps rates stay lower than they otherwise could be, on average.

The two basic building blocks of a mortgage-backed security are the CONSUMER who wants to borrow money (a mortgage, in this case), and an INVESTOR that wants to lend money in order to earn a return on investment. No matter what you’ve heard about MBS, Fannie, Freddie, FHA, and other government programs, MBS cannot and will not exist without consumers who want to borrow and investors that want to lend.The remaining facets of mortgage securitization grow from those two building blocks.

How do investors benefit?

Investors want to lend, but they also want to be protected from risk. If one investor with $200k only made one loan to one consumer, and that consumer defaulted, that investor would shoulder the burden of the entire loss.

Even if that investor has $1 million, and makes 5 loans for $200k, depending on the rate of default, the investor could easily experience a very different rate of return than another investor with the same amount of money investing in the same kinds of loans.

Naturally, if the investor was a gifted underwriter with a perfect eye for risk in assessing potential borrowers, he or she could greatly reduce the risk of default for his or her investments. Lenders attempt to do this anyway, but even if we factor out underwriting standards and the loan process, securitizing loans into MBS reduces risks for investors.

Reducing Risk.

Risk is reduced because securitization allows it to be “spread out” among similar loans. Consider the hypothetical scenario for an investor:

- Average loan amount: $200k

- Default Rate = 1 in 20 loans

- Loss per default = $50

This investor has a 1 in 20 chance of losing $50k for every $200k they lend. If 20 investors each made one of these loans, 19 of them would be profitable and one of them would be out of business. They need a way to share this risk equally!

If Investor A and Investor B can afford to make 20 loans each, chances improve that actual defaults will match the anticipated default rates, but even if the default rate is accurate, Investor A could be holding both of the loans that default while Investor B holds none. These two investors STILL need a way to share risk equally!

Securitization accomplishes this goal of risk-sharing. It allows both of the investors in the example above more certainty as to the default rate. It’s a trade-off between the small chance of big losses and a near certainty of small, predictable losses. Investors will take the certainty every time because if they can reliably predict the risk, they can easily adjust the price to account for that risk.

In the example of 20 investors each making 1 loan of $200k, if they “pool” those 20 loans together, and if the advertised default rate holds true (1 in 20), then they’ll have only one $50k loss divided amongst them ($2500). In this way, the investor has traded the 5% chance of a $25% loss for 100% chance of 1.25% loss ($200k x 1.25% = $2500). Knowing that the 1.25% loss is coming makes it easy to adjust the price so that the lender is profitable and can stay in business.

Conclusion on Securitization

Securitization is helpful for several reasons. The greater the certainty with which lenders can predict losses, the smaller the margins can be that protect against losses. This translates directly into lower rates for consumers.

Securitization also means investors can buy a piece of a mortgage portfolio without financing every mortgage in it. This is akin to buying stock in a company rather than the company itself, and it allows for far greater participation in the mortgage market among investors. More participation makes for a more liquid market where buyers and sellers can be relatively more assured of finding other willing buyers and sellers near current prices. This also reduces margins in the secondary mortgage market, incrementally benefiting rate sheets.

Of course there are downsides to this model. One might argue that the level of detachment between investors and the loans in which they were investing in the run-up to the financial crisis was one of reasons for the crisis. Indeed, it would be hard to argue otherwise, but the benefits of securitization (much more liquidity in mortgage markets, more loans for more people, lower rates, and less risk for investors) will likely be seen as outweighing the costs (detachment masking the real risk of loss, borrowers having to fit the underwriting mold of housing agencies) for the foreseeable future.

NOTE: none of the following is meant to suggest that today's Fed communications will not have an impact on rates. They absolutely can and almost certainly will. The point is that the Fed rate hike itself has no functional connection to mortgage rates (except in the rare cases of certain lines of credit that are based on the PRIME rate which is indeed linked to the Fed Funds Rate).

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Apart from the small minority of loans like certain lines of credit that are actually tied to the Fed Funds Rate, there's a common misconception that the Fed "sets" (or hikes/cuts) mortgage rates directly. Even among people who know better, there is often a belief that changes in the Fed Funds Rate (the thing the Fed actually hikes/cuts) translate in some direct way to changes in mortgage rates.

No...

What is the Fed Funds Rate?

The Fed Funds Rate is a target set by the Fed for interest charged by big banks to lend money to each other on an overnight basis. It has several policy tools that ensure the target is reliably hit within a quarter of a percent margin (one reason that the Fed communicates rate targets in 0.25% windows).

In other words, the Fed "decides" (for lack of a better term) what the shortest-term loans will cost. From there, the market decides what longer term loans will cost. Whereas the Fed Funds Rate pertains to loans that last 24 hours or less, the average mortgage lasts 3-10 years depending on the housing and mortgage environments at any given moment in history.

To understand why that matters, we need to understand the role that "duration" (market-speak for the life span of a loan) plays in the bond market.

We also need to understand what any "interest rate" really is. Of course, we know a rate determines how much interest is paid on loans, but let's connect the dots from "loans" to financial markets since financial markets ultimately determine loan rates!

In market speak, "loans" = "bonds." Bonds are investments that can be bought and sold. They have a PRICE (what the investor pays for the bond) and a YIELD (the rate of return the investor receives over time). The combination of that price and yield determines the rate paid by whoever is ultimately footing the bill for the interest.

NOTE (advanced concept): the price can be different from the face value of the bond (i.e. an investor could pay $102 for a $100 bond based on the rate of return being offered. Similarly, the yield of a bond can be different than the rate that is actually paid by the borrower (i.e. a borrower might pay 4% interest on a $100 bond but the yield would be lower if the investor gave the borrower $102). For the purpose of this primer, we will ditch the confusing bond math and just assume that PRICE = FACE VALUE (or "principal" in lending terms) and YIELD = INTEREST RATE.

For instance, a 10yr Treasury note is a bond issued by the US government that allows investors to pay a lump sum and then to receive payments, with interest, from the US government over the course of 10 years.

A mortgage backed security (MBS) is a bond that determines mortgage rates. It can last up to 30 years in the case of a 30yr mortgage, but because most mortgages are refinanced or closed before that, MBS end up lasting less than 10 years on average. On the other hand, they last significantly longer than the overnight loans subject to the Fed Funds Rate.

The life span of a bond has an important bearing on the value of that bond. The rate outlook has a direct bearing on investor demand for certain lengths of loans. If you expected rates to be much higher tomorrow and you were an investor looking to lend money, wouldn't you wait until tomorrow?

The Fed Funds Rate is never subject to such considerations because it only ever applies to the shortest possible lending terms. If you wished you'd waited to lend until tomorrow, no big deal! Because you'll have your money back to lender tomorrow anyway!

But when investors decide to put money into longer term bonds like various US Treasuries or mortgage-backed bonds, there's much more to consider. Perhaps the economy and inflation are seen declining over time such that an investor could only expect a 3% return over 10 years instead of a 4% return over 5 years.

Why not just take the 4% for 5 years? Because you'll get your principal back in 5 years and what will you do if the new 5 year rate is 1%? Perhaps you will wish you'd locked in that 3% rate of return for 10 years instead. This is why different durations of bonds/loans can have different interest rates and why they can move in different ways over time.

So why do long term rates like mortgages sometimes react so much to Fed announcements?

The Fed may not set mortgage rates directly, but they can still say/do things that have a tremendous impact on all manner of interest rates. One of the most notable examples is that of QE or Quantitative Easing. This was/is the Fed's policy of buying Treasuries and Mortgage-Backed Securities in large amounts in an attempt to promote its policy goals. Changes to QE policies--especially when they're unexpected--have a far greater impact on long-term rates than the short-term Fed Funds Rate.

I thought you said the Fed Funds Rate didn't matter, but you just implied it had an impact. What gives?!

Yes, the Fed Funds Rate absolutely has an impact on longer-term rates like mortgages. And yes, the Fed definitely hikes/cuts the Fed Funds Rate. But the catch has to do with timing.

The Fed meets 8 times a year to discuss changes in monetary policy. Apart from emergency, unscheduled meetings, these represent the 8 chances the Fed has to hike or cut the Fed Funds Rate. Contrast that to the bond market (the thing that actually dictates mortgage rates), which is trading every millisecond.

Traders aren't going to wait for the Fed to actually pull the trigger on a rate hike if they can be reasonably sure it's coming. Indeed there are entire groups of market securities devoted to betting on the Fed Funds Rate in the future (incidentally named "Fed Funds Futures").

These futures typically price-in most upcoming Fed rate hikes/cuts with near 100% accuracy. This hasn't always been the case, but it is more and more common in this age of tremendously transparent speeches from Fed members. For instance, if 7 out of 7 Fed speakers over the past month have all mentioned that they're leaning toward a 0.75 hike to the Fed Funds Rate, it's essentially guaranteed and the bond market has long since changed accordingly.

Because the market can show up to the party so far in advance of the Fed itself, it's not uncommon to see mortgage rates move in the opposite direction of the Fed on the day the Fed actually makes its move.

Additionally, on announcement day, the Fed's verbiage and especially the Fed's Summary of Economic Projections (which only come out with 4 of the 8 Fed announcements per year) can have a huge impact on the market's rate outlook over time. Those projections include a dot plot of the Fed Members' individual rate forecasts.

Bottom line: the Fed hike (or cut) itself is often old news by the time it happens, but the verbiage and the forecasts help the market refine its understanding of where short term rates may be headed in the future. That's a BIG deal!

Ultimately, if you knew where the Fed Funds Rate would be every day for 10 years, you'd also know exactly where the rate of a 10yr loan should be today. Granted, there are a few other considerations that put the finishing touches on exact rate levels (especially true of mortgages), but this notion of longer term rates being driven by the expected future levels of short-term rates is at the core of interest rate momentum and volatility.