Mortgage rates have been all over the map recently, both in terms of their movement and in their variation between lenders. It’s not altogether uncommon for certain borrowers to be seeing rates that are half a point lower than they were just last week and a full point below the mid-June highs.
This is an exceptionally fast drop! Perhaps even more interesting (and uncommon) is the fact that mortgage rates have dropped faster than US Treasury yields. It’s typically the other way around as investors flock first to the most basic, risk-free bonds.
So why are mortgages winning the race this time? There are a few contributing factors, but the most notable is the structure of the underlying mortgage bond market.
A quick disclaimer/warning before proceeding: there’s really no great way to talk about what’s going on without things getting a bit esoteric. If it’s all a bit confusing, that’s normal. We’ll cordon off the most esoteric stuff in the six steps below, but you’ll need to it to understand the thesis below.
Step 1: Mortgage rates are based primarily on mortgage-backed securities or MBS. As lenders originate mortgages, those mortgages can be “turned into” MBS and sold to investors who want to earn interest on mortgage debt.
Step 2: MBS have a coupon–which is the official rate paid out by a bond. Other bonds, like the 10yr Treasury Note, also have coupons.
Step 3: MBS have a price. Same story for a 10yr Treasury note. This is the price an investor pays to own $100 of that bond. A price can be higher or lower than $100. If I pay more than $100 for a bond with a hypothetical coupon of 4%, I’m technically earning less than a 4% rate of return because I paid more upfront. Coupons are periodically set in stone and the bond market moves by changing the price it pays for that coupon. The combination of price and coupon allows investors to know the actual yield associated with a bond. So when you see 10yr yields moving all over the place every day, the coupon never changed. Just the price.
Step 4: Unlike Treasuries, which change coupons only one per quarter, MBS coupons are offered in half point increments (i.e. 4.0, 4.5, 5.0, etc) and are always available for investors to buy/sell.
Step 5: In other words, investors have CHOICES TO MAKE when it comes to which MBS to buy. Investor demand for any given coupon can wax and wane for multiple reasons. In general though, when investors think the broader rate market has topped out or that rates will continue to move lower, they prefer to buy the lowest MBS coupons possible.
Step 6: Mortgage lenders have choices to make when it comes to choosing an MBS coupon to place their recently originated loans into. There are boundaries here. Any given MBS coupon is limited to mortgage rates that are between 0.25% and 1.125% above that coupon. e.g. a 4.0 coupon MBS is like a bucket that can only hold mortgages with rates of 4.25% through 5.125%.
Now that you have a perfect, internalized understanding of the structure of the mortgage bond market, we’re ready for the punchline. Due to those “choices to make” regarding which MBS coupons to buy/sell, the price of one coupon can move more easily than an adjacent coupon. In the weeks following long-term highs in rates, when the market may be sensing a new trend toward lower rates, investor demand shifts heavily in favor of “the next lowest coupon.”
The “next lowest coupon” isn’t always a viable option. For instance, just last week, when rates were in the mid to upper 5s, offering 30yr fixed rates of 5.125% would have been too big a drop for most mortgage lenders to entertain (remember, 5.125% is the cut-off for a 4.0 MBS coupon).
Meanwhile demand for those 4.0 coupons have increased steadily, relative to 4.5 coupons. 4.0 coupons are so much more sought after that a mortgage rate of 5.125% earns a mortgage lender MORE money than a rate of 5.25% when they turn your loan into MBS and sell it. Many lenders are offering 5.125% rates with terms that are very similar to 5.375% rates.
That may not sound like a big deal, but consider that during more stable times, it could cost a full “discount point” (1% of the loan balance) to “buy down” a rate by 0.25% (the difference between 5.375 and 5.125%) whereas today it costs roughly 1/10th of a point.
Bottom line: the distance between adjacent MBS coupons grew so small that it didn’t take as much of a bond market improvement as it would normally take for lenders to make the jump down to the rates associated with the lower coupon.
NOTE: in some cases, advertised rates may indeed involve some upfront points. That’s because it may only take a fraction of a point to bring the rate into the next lower MBS coupon bucket. In other words, points have a lot of bang for their buck right now. That doesn’t mean it’s the best option (after all, if rates keep falling, you’re going to wish you didn’t pay any upfront points)–just a phenomenon that helps us reconcile big changes in mortgage rate headlines and indices.
So where are rates today? That really depends on the lender doing the quoting. Some could be legitimately quoting rates in the high 5s still. We’d hope there are no additional “points” in those cases. Other lenders are quoting 5.125% to be sure, and some are already back into the high 4’s. In general, the lower the quote, the more likely it is to involve discount points.
Last but not least, it should be noted that Thursday itself was a very big day for rate movement due to the bond market’s reaction to the negative GDP number released this morning.