Your Mortgage Is Priced Off a Bond You Will Never Own

A Strange Week to Read the Two Numbers Together

This week the thirty year Treasury yield jumped to 5.34 percent, the highest since 2007, and government bond markets in France, Germany, and Japan to post their longest weekly streaks of record highs in decades. It was clearly not a week to be long in the fixed income asset class.

Yesterday Freddie Mac survey reported that the average thirty year fixed mortgage rate was 6.65 percent, down from 6.67 percent the week before, and 6.69 percent the week before that.

That seems like a paradox, and it isn't actually because government yields surged while mortgage rates barely changed, but understanding why is essential to actually understanding how a government bond market works at the personal level, since their connection, while real, is indirect and delayed.

The Handoff Nobody Explains

Let's begin with the obvious, which is that mortgage rates are not actually determined by the Federal Reserve. That misunderstanding causes people to expect far too much when it comes to changes in their housing payments, and not nearly enough when it comes to the power of their personal financial decisions relative to the broader market.

The federal funds rate, which is actually what the Federal Reserve does have control over, is a very short term rate, currently between 3.50 and 3.75 percent, while a thirty year mortgage is clearly not priced with a three day loan in mind. The thirty year mortgage rate actually reflects the market's expectations of where the ten year Treasury is likely to be, which in turn contains information about the outlook for inflation over the next decade or so.

The connection to another thirty year security may seem logical, but a mortgage has a different expected maturity due to prepayments, so the real comparison is to the ten year note.

The ten year yield, currently near 4.74 percent, has recently been a far more important indicator for mortgage rates, because while a mortgage is theoretically a thirty year loan, most mortgages are ultimately outstanding for only about a decade. That has implications for how much risk is built into the loan, and thus for what interest rate borrowers have to pay to compensate lenders.

All of this means that a change in the fed funds rate can have only an indirect effect on mortgage rates by influencing the outlook for inflation, and thus for long term yields. It can also be negative, if the market interprets the action as a sign that the Federal Reserve is comfortable with higher inflation than previously expected.

The Margin Sitting on Top

A mortgage rate is actually the yield on the ten year Treasury plus a spread, and that spread has recently been larger than usual, which explains why at 6.65 percent, mortgage rates still greatly exceed Treasury yields of 4.74 percent. In fact, the spread was close to 1.9 percentage points in recent days, after generally running between 1.5 and 1.7 points throughout the life of the current recovery.

The reason for the spread is actually very straightforward, because a mortgage is more risky for the lender in a particular way compared to other fixed income assets, and that risk needs to be compensated by a higher interest rate in order to attract investors.

It has nothing to do with a default; the problem is that the lender cannot control when it will receive the money back from the loan, and the risk is ultimately skewed as rates rise and fall.

If rates fall, the borrower will almost certainly refinance and leave the lender with a reduced coupon. Since that outcome is far more favorable for the borrower and far less favorable for the lender, a larger risk premium is required to compensate the latter, which makes the spread a reflection of market optimism about future rates.

As a result, a spread generally increases when volatility rises, because the embedded option becomes more valuable to the borrower, giving another reason why a bond market spike will often pressure mortgage rates even if long yields eventually settle down.

Why the Survey Lagged the Selloff

That still leaves us with the paradox about why the survey lagged the selloff, and the reason is actually relatively simple. The Freddie Mac survey is a survey, and it always reflects market conditions as of a specific point in time, but most loan applications are processed over multiple days and incorporate prevailing quotes throughout the period.

As a consequence, a spike in yields on Tuesday will not necessarily show up in a survey that ends on Thursday, since the majority of applications in that week will have been processed before the spike occurred. Two other relevant factors, however, were that the Treasury announced plans to double the size of its bond repo program, which caused yields to subsequently drop back towards the end of the week, and that lenders simply do not update individual rates as frequently as headlines suggest.

They tend to average quotes on a rolling basis with outstanding applications in order to smooth out changes across weeks. The practical implication is that if longer term yields remain at these levels, they are almost certain to show up in survey results over the next few weeks, with only a delay.

What This Actually Costs

The value of an interest rate is generally best evaluated in context, so let's use the example of a $400,000 loan and examine how costs change based on rate.

The most relevant column in this particular case is the total interest paid over the life of the loan, since that is almost always the primary cost to the borrower. At 6.65 percent a loan of this size would generate interest payments of roughly $524,000, which means that the borrower ultimately repaid more than the principal. In fact, the costs are far higher than at any point during the last several years, because the Fed's average mortgage rate last year was only 6.58 percent, implying a difference of roughly $19 per month on this loan. By comparison, the jump from 6 percent to 6.65 percent translates to an additional $170 per month on this loan, meaning that daily fluctuations in rates matter far less to most borrowers than the overall level.

The Rate You Already Have Is an Asset

There is, however, another consequence of persistently high rates that has implications for mortgage markets that nobody really writes about. A borrower who has already locked in a mortgage at a historically low rate effectively holds an asset that will become worthless when they sell their house, because they will almost certainly have to replace a mortgage with a far higher monthly payment when buying a new home.

This has implications for a market in which most buyers are actually attempting to buy an existing home, with the number of existing homes on the market at any point in time being heavily influenced by the preferences of current homeowners. A rising rate environment discourages selling because of this dynamic, which allows prices to remain supported even in the face of higher rates. As a consequence, there is often a situation where buyers feel that prices are too high, even as many homeowners believe that prices are too low, which is obviously not possible at the same time.

For most people, the practical implication of this particular situation is that their existing mortgage rate is an asset with economic value, and that the decision to sell a home should always account for that fact, because the replacement loan can be exceptionally expensive if the payment is significantly higher.

The Product Itself Is Unusual

There is another factor that tends to get neglected when it comes to mortgage markets, and it is that the thirty year fixed rate mortgage itself is largely an American innovation.

In other countries, mortgages tend to be either short term or contain features that reduce the value of the prepayment option available to American borrowers.

The reason why that distinction is important is actually tied to our discussion of the value of the prepayment option, because the ability to lock in a rate at a specific moment in time is extremely valuable to borrowers, but it is also why the spread tends to be higher for mortgages. Essentially, when rates fall borrowers take advantage of the situation and lower their payments, but when rates rise they continue to pay the same amount.

This leaves the lender with a fixed coupon that is less valuable when rates rise, which is essentially a risk for the lender that needs to be compensated by the borrower. In practice, that compensation takes the form of the higher rate that borrowers currently observe, and the risk is rarely borne entirely by the company that actually originates the loan.

Most mortgages are subsequently securitized and sold to investors in the capital markets, which means that the risk of widespread refinancing is actually borne by the people who purchase those mortgage-backed securities. At the most basic level, the rate you are offered reflects what investors are demanding for taking on that risk, and those investors are essentially the ones on the other side of the rate trade described earlier.

The practical implication of that discussion is that locking in a rate today is not a speculation on the path of rates, but rather a purchase of protection against higher rates combined with a convenient option to benefit from lower rates at a later date. For most borrowers, it is actually an incredibly advantageous position to be in, and one worth considering before opting for an adjustable rate mortgage, since the latter will always have a lower payment at the initial closing, but comes with significantly increased risk exposure.

Car Loans and Credit Cards Follow Different Rules

Not all interest rates follow the same rules, and understanding those differences is critical to actually navigating personal finance.

Auto loans generally have a much shorter maturity, between three and seven years, and therefore follow general trends in shorter term interest rates. The spread to those rates is generally larger, and the rates themselves are highly dependent on the borrower's credit history and whether the vehicle being purchased is new or used. Auto loans are generally much more sensitive to changes in the federal funds rate, but the connection is not direct either. Credit cards, on the other hand, tend to follow the prime rate almost consistently, with rates reset roughly every month in accordance with changes to the Federal Reserve's policy rate. The "prime rate" reflects the rate banks charge their most creditworthy customers, and most card issuers then add a spread to that based on the risk of individual borrowers. As a consequence, credit card rates are far more sensitive to direct changes in the Federal Reserve's policy, and those changes should actually be watched more closely by consumers, because those rates tend to be the highest that most people face on a regular basis and therefore have the most influence over a household budget.

The Side of This That Pays You

Higher rates are generally viewed as a negative for borrowers, while lower rates are clearly beneficial to people who hold cash, but that perspective overlooks the value of an asset the most people fail to actually hold.

The current federal funds rate is between 3.50 percent and 3.75 percent, implying that very short term government debt currently offers significantly higher yields than at any point since the financial crisis. Cash is no longer a losing proposition compared to inflation, which is currently running at 3.4 percent, and a yield of two to three percent on cash is roughly consistent with a competitive return on a low-risk portfolio, without exposing the investor to significantly higher risk.

The opportunity for competitive returns is actually quite large at this point in the market cycle, with the potential for returns across the spectrum from virtually nothing to four percent, depending on where the cash is held. The reason why the cash yield is relevant is because most investors will have a default savings option at their primary banking institution and will leave money there rather than searching for a competitive rate. That is an opportunity cost that can be eliminated with minimal time and effort, because finding a competitive savings rate only takes an afternoon and requires no special knowledge.

What the Opportunity Cost Is

There are actually two opportunity costs worth mentioning with regard to this particular discussion. The simplest opportunity cost is the one associated with watching cash yields rise without investing in anything besides the default savings account at one's primary bank.

The more valuable opportunity, however, is the one associated with failing to recognize the risk/reward tradeoff embedded in every investment decision, and the value of a cash position in particular.

Most people who actually understand finance recognize that lower rates mean higher valuations for assets at purchase, but the opportunity cost of holding an asset that offers a negative return is not typically appreciated. Lower rates reduce the value of cash, while higher rates increase it without changing the fundamental value of the underlying asset. This makes higher rates a positive for most cash investors, assuming they hold high-quality cash equivalents, while lower rates create a situation in which those investors are actually paying to own the asset. The most important opportunity cost associated with this discussion is that most people have failed to account for the opportunity cost of an uncompetitive savings account, and it is one that can be remedied with minimal research.

What Not to Do With This Information

It is worth highlighting two mistakes that are easy to make with regard to the information discussed above.

The first is to attempt to time the bond market, since a dramatic week like the one we've recently witnessed can suggest that the trend is about to change.

There is no reason to believe that either outcome is particularly likely at this point in the cycle, because changes to long term yields are generally dictated by the need for government borrowing and the outlook for inflation over the long term, both of which are difficult to gauge for a household on a personal level. If you need a house, buy one when you think the payment works and the timing is right.

The second common mistake is to reach for yield, since higher rates on higher quality assets reduce the risk/reward profile on other assets.

In other words, the opportunity cost of reaching for yield with assets that are actually supposed to be completely safe is rarely appreciated. If short term government bonds pay close to the rate of inflation, an investment product promising much higher yields is compensating the investor for assuming additional risks, even if those risks are not described explicitly.

The Bottom Line

The bond market had a volatile week and mortgage rates barely moved, and both are true because the connection between them is indirect and delayed. Mortgages primarily reference the ten year Treasury note, because a mortgage is priced based on the expected life of the loan and the implied inflation outlook. They also tend to include a larger risk premium due to the value of the prepayment option, and their relationship to the Federal Reserve is indirect at best, because changes to the fed funds rate are relevant to inflation, and therefore to long term yields. The most important thing about mortgage rates is the general level rather than the week to week variation, and while a $400,000 loan at 6.65 percent would result in a payment of almost $3,000 per month, the total interest paid would be just about where it was a year ago at this time. The opportunity cost is not the next week's change in rates, and it definitely does not involve waiting for the Federal Reserve to do something, because the only thing the Federal Reserve is likely to do is change what the short term rate says.

Meanwhile, the bond market environment actually includes significant opportunities for cash investors, and those investors have not taken advantage of those opportunities for quite some time. It is easy to overlook the cash position when examining personal investments, but it is the one component of a household balance sheet that most people actually control.