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When Will the Mortgage Party Be Over?

house on pile of mortgage money

Is the low mortgage rate party about to end?

You probably know that mortgage rates change every day. When the market is volatile, lenders may even change their prices a couple of times during the day. There is a reason for this—and it’s not because some banker is throwing darts at a rate chart.

Here’s how it really works.

You have survived the ordeal of getting your loan approved. You have signed your name a thousand times on a two-foot stack of forms and have terminal writer’s cramp. As the feeling is returning to your fingers, your loan officer calls and says, “Your loan has funded!” This means that the lender has wired your money to escrow and your transaction is complete. Your Realtor© hands you the keys to your new home.

Shortly after, even before you have unpacked your coffee maker, you get a letter from the bank telling you that your loan has just been sold. Huh? Is this some kind of fiscal “Dear John” letter? After all you’ve been through, the bank wants to dump you?

Don’t take it personally; this is just how the mortgage business works. The bank has just sold your loan for a small profit to the investor, who will hold the loan for a longer time. Your loan, along with thousands of others like it, will be bundled into a type of bond called a Mortgage Backed Security (MBS). These bonds are bought and sold on Wall Street just like any other type of bond. When the investors are buying MBS, it makes their price go up. When they are selling them, the price goes down.

On any given day, the price of that bond may fluctuate up or down by around 25 basis points (25¢ per $100 worth of value). The mortgage bank that made your loan sets its pricing by what they can sell your loan for. If the bond market improves by 25 basis points from one day to the next, it would mean that your lender can to sell your loan for .25% more on that day. They typically pass that improvement on to you. If you are borrowing $300,000, that improvement would lower your cost by $750.

Those MBS are a fixed-rate investment. This makes them sensitive to inflation—or fears of inflation. Since the income from those bonds doesn’t change, inflation eats away at both the value of the principal and the value of the cash flow. Mortgage rates have been so low partly because inflation (and fears of inflation) is so low, but also because there is another force in the market supporting the price of the mortgage bonds.

That force is a little outfit called the Federal Reserve. The Fed has the ability and the wherewithal to stimulate the economy or slow it down. Their primary tool in the past has been the Federal Funds Rate. This is essentially the rate banks pay to trade money with the Fed and with each other. The Fed can set that rate low in order to stimulate the economy, or raise it to slow it down, reducing inflation.

Here’s the problem: the Federal Funds Rate has been at zero since the end of 2008. The Fed has no more bullets in their interest rate gun. So they have resorted to other ways to stimulate the economy. That’s where QE3 comes in. No, it’s not a brand new luxury liner. It is the Fed’s Quantitative Easing policy—version 3.0. Since they can’t lower the Federal Funds Rate below zero, they operate in the market directly, buying mortgage bonds at the rate of around $40 billion each month. This is why mortgage rates are so low today. The Fed is a huge institutional buyer with unlimited money, supporting the bond market every month.

You might ask when the party will be over. They can’t keep up this buying spree forever—and aren’t they going to start unloading all those bonds? The answers are “true,” and “probably not.” As the economy continues to show signs of life, the Fed will stop buying bonds (probably around the end of 2013). The good news is that they have said that they are prepared to hold all these bonds to maturity—as long as 30 years. That means we’re likely to see these insanely good rates at least through the end of this year.

See how simple it all is?

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