Why are Mortgage Rates So High?

It’s all about the spread

Home mortgage rates are higher than usual compared to long-term treasury bond rates. Experts in the mortgage industry are wondering if the difference will go back to normal, meaning lower mortgage rates as long as treasury interest rates stay stable. However, this may not happen in 2023.

Historically, the gap between mortgage rates and treasury bond rates is wide. Before the pandemic, the average difference was 1.69 percentage points. For instance, in February 2019, 10-year treasury bonds had an interest rate of 2.68%, while the average 30-year fixed-rate mortgage was at 4.37%. This 1.69% difference aligns with the long-term average. Usually, the spread falls between 1.5% and 2.0%.

Here's how the process works: Homebuyers approach a mortgage originator, typically a mortgage broker or a bank, who provides an interest rate quote. The originator then sells the loan, usually to a government-sponsored entity like Fannie Mae or Freddie Mac. The mortgage originator receives payment for their services, similar to a middleman's role. This payment compensates for the increase in the interest rate. For example, during the first week of 2020, the average mortgage interest rate was 3.72%, while Fannie Mae paid investors an average interest rate of 2.61%. The 1.11% difference served as payment to the mortgage originator. This payment is referred to as the retail mortgage spread.

When Fannie Mae or Freddie Mac sell a bundle of mortgages to investors, the interest rate is influenced by supply and demand. Generally, investors consider mortgages inferior to treasury bonds. Both are considered safe, but treasury bonds guarantee interest payment for the bond's duration. On the other hand, homeowners have the option to refinance their mortgages when interest rates drop. This means that when rates decrease, homeowners refinance, and investors are left with cash they must reinvest at lower rates. Naturally, investors are not pleased with this situation.

When interest rates rise, investors face another challenge. They are left with old mortgages that have low-interest rates, and homeowners are unlikely to pay them off early. Investors would prefer to get their cash back and invest in new mortgages with higher interest rates, but that's not happening.

The option for homeowners to refinance their mortgages makes mortgage-backed securities less attractive to investors. Consequently, investors only purchase them if they offer a premium over treasury bond rates. This is known as the wholesale mortgage spread.

At any given time, the total spread is the sum of the retail spread and the wholesale spread. In the first half of 2020, the total spread widened significantly. This was due to the Federal Reserve lowering interest rates while the government provided stimulus checks. Homeowners took advantage of the lower rates and refinanced their mortgages, while apartment dwellers, armed with cash and low mortgage rates, started looking for homes. Mortgage originators were overwhelmed with business, leading to higher profit margins as they struggled to keep up with the public's demand for refinancing. The retail spread increased substantially, while the wholesale spread only rose slightly. William Emmons of the Federal Reserve Bank of St. Louis documented this trend.

The wide spread between mortgage rates and treasury bonds in early 2023 seems to be primarily caused by the wholesale level. Bond traders attribute it to the volatility of interest rates. When interest rates rise, mortgage-backed security owners receive fewer prepayments, which they desire. Conversely, when interest rates fall, owners receive more prepayments, which they do not want. As a result, the prospect of interest rate fluctuations in either direction discourages investors from investing in mortgage-backed securities.

At the retail level, some spread widening is expected due to the mortgage originator's interest.

To learn more, contact us so that we can put you in touch with a lender that will answer your questions and meet your needs.