Have you ever noticed how oil prices can plummet, but the cost at the pump doesn’t drop nearly as fast? It’s a similar story with U.S. Treasury yields and mortgage rates. Even though mortgage rates are influenced by the 10-year U.S. Treasury bond yields and generally move in the same direction, they don’t adjust as rapidly or to the same extent. This is largely due to the complexities and various types of mortgages available, which introduce certain frictions in the adjustment process.
Recently, Treasury bond yields have hit record lows, but surprisingly, mortgage rates have soared to their highest since 2012, driven by significant inflation. You might wonder why there’s such a lag in the adjustment of mortgage rates compared to Treasury yields. The main reason is risk—but not necessarily the risk you might think of, such as defaulting on payments. Instead, the risk lies with investors of mortgage-backed securities (MBS), who pay extra for these bonds in anticipation of profiting from the interest paid by borrowers over time.
These investors face a risk when homeowners decide to pay off their mortgages quicker or refinance when rates drop. This scenario cuts into the expected long-term gains from the original interest rates of the mortgages. For example, if a homeowner refinances or sells their home earlier than anticipated, it can equate to financial losses for the investor, much like a homeowner who pays points to lower their rate but then sells or refinances before reaching the breakeven point on those costs.
Here’s a practical example from my own experience: I had a 30-year fixed mortgage with Citibank at 4.625%, which was then sold to another lender. Shortly after, I refinanced to a 5/1 ARM at a much lower rate of 3.375%. This refinancing, completed in about three months, meant that the investor who bought my original mortgage didn’t earn nearly as much interest as expected, and only for about 11 months. Several years later, I refinanced again at an even lower rate and eventually paid off the mortgage entirely.
When you find yourself puzzled by the behaviors in the finance world, consider looking at the situation from an investor’s perspective. Understanding their side can make you a better negotiator, a smarter investor, and even a more empathetic individual during disputes.
For instance, when unexpected events like a pandemic occur, and rates drop rapidly, the risk of mortgage prepayment rises, leading investors to demand lower premiums for MBS. This results in banks offering higher rates or upfront costs to borrowers, hence mortgage rates don’t decrease as much as Treasury yields.
So, while mortgage rates have recently fallen to an eight-year low, it’s uncertain whether they will reach all-time lows like the Treasury yields. Banks, much like gas stations, may decide to keep rates slightly higher in anticipation of yields rising again to make a higher profit. However, if they’re wrong, they risk losing significant refinancing business to competitors who offer more attractive rates.
Furthermore, some banks may maintain higher rates simply because they’re overwhelmed with applications and lack the staff to process them quickly—an issue that recently delayed my mortgage refinancing by an extra month.
Real estate remains my preferred investment for achieving financial freedom due to its tangible nature, lower volatility compared to stocks, and potential for income generation. And while exploring new investment opportunities, always shop around for the best mortgage rates to ensure you’re securing the best deal possible for your financial situation.
