Why are Mortgage Rates Going Up Instead of Down?
Since the first glimpses of the COVID-19 pandemic in the US, many of our Buyer and Seller clients have been reaching out to us with questions about the housing market—among the most common questions are those regarding interest rates for new mortgages and refinancing.
In early March, there were many news headlines about the mortgage interest rates decreasing. This created a new sense of urgency for many people to buy a home or refinance their existing mortgage. We wrote this piece to help answer your questions about mortgage rates in the age of COVID-19. While there are many more technical articles written for mortgage bankers and financial analysts, this piece is intended for consumers without formal finance education.
When COVID-19 first started becoming a concern in the US in early March, but before Governor Wolf ordered non-life sustaining businesses in PA to close, the Federal Reserve lowered the target range for the federal funds rate to 1% – 1.25% on March 3. The federal funds rate is the interest rate that banks charge when they lend money to other banks to meet their required reserve levels. When the federal funds rate goes down, it costs banks less to borrow the money they need to lend money to homebuyers. As a result, interest rates decreased for mortgages—both new loans and refinanced loans.
Then, on March 15, the Federal Reserve took even more drastic action: Based on concerns about risks to the US economy due to the COVID-19 outbreak, the Fed reduced the federal funds rate to zero (a range of 0% to ¼%). As a result, many people expected mortgage interest rates to go down even further. Instead, they actually went up. Why?
The complete answer is fairly complicated, but we’ve tried to distill it down to a relatively simplified explanation:
Servicing Challenges
When a loan closes, the lender typically sells the loan to an investor, and the right to service the loan to a servicer (though sometimes lenders service their own loans). The servicer collects the mortgage payments from the borrower, forwards the payments to the investor (who actually owns the loan), forwards taxes and insurance to the municipalities and insurance company, etc. Because the servicer pays for the right to service the loans, it takes about 3 years for the servicer to break even and start earning a profit on each new loan. When interest rates go down and people refinance, the servicer doesn’t even break even on many of their newer loans—they lose money.
To make matters worse for the mortgage lending industry, COVID-19 has caused the US economy to virtually shut down, causing a historic number of people to lose their jobs. When people lose their income, they are less likely to pay their mortgage on time. However, the mortgage servicers are still responsible for paying the investors who own the mortgages, even if they haven’t received the money from the borrowers. While servicers have cash cushions to account for this delay, an extreme number of borrowers not making their payments creates serious financial problems for the servicers.
Mortgage-Backed Securities
When a loan gets sold to a servicer, the investor bundles the loan with many other loans. These bundles get converted into products called Mortgage-Backed Securities. These securities can be sold to the public in investment products like mutual funds and IRAs. As Mortgage-Backed Securities rise in price, interest rates on new mortgages move lower. This is because lenders are incentivized to write more mortgages because they are worth more when they sell them. They do this by offering lower interest rates.
When a borrower “locks” their interest rate, the lock is essentially a promise by the lender to hold the borrower’s interest rate for a period of time (typically until the loan closes). If interest rates go up, the lender is obligated to “buy down” the borrower’s rate to honor what was promised in the lock. To “hedge” (protect) against this happening (and losing money), lenders bet on the Mortgage-Backed Securities decreasing in value by taking a “short position.” This means they borrow Mortgage-Backed Securities at the current price, sell them immediately, and then use the money to buy the securities when the price is lower. When they return the original number of borrowed securities, they keep the difference between the higher price they sold them for and the lower price that they paid for them before they returned them. Lenders use this income to offset the cost of having to “buy down” borrowers’ interest rates when rates go up.
In an effort to reduce mortgage rates, the Federal Reserve has been buying large volumes of Mortgage-Backed Securities, causing their price to rise very quickly. This large and rapid increase in the price of Mortgage-Backed Securities causes lenders to lose a lot of money on their short positions because they end up paying more for the securities when they must return them than what they sold them for upfront.
A Perfect Storm
So, several things are all happening at once—resulting in a “perfect storm” for mortgage lending.
- When the Fed Funds Rate went down, lenders started lowering mortgage interest rates, and lenders began losing money on their hedges (protections) against interest rates increasing.
- Servicers (and lenders who service loans) are losing money because they have to pay the investors who own the loans, even if borrowers can’t pay their mortgage because they lost their job. This is also making it more difficult for lenders to sell their loans after they close (servicers must take more financial risk because they know that many borrowers who lose their jobs won’t be able to pay their mortgages).
- Before loans that were already in process can close, the borrowers’ employment has to be verified. With millions of people losing their jobs, those mortgages cannot close, causing lenders to lose even more money (their hedges are losing money because interest rates are going down, and they can’t sell loans that don’t close to investors to offset those losses).
- When the Federal Reserve reduced the federal funds rate to almost zero, it did not educate the public that this rate is very different than mortgage rates. As a result, many people tried to take out new mortgages and refinance their existing mortgages to take advantage of low-interest rates. This flood of new loans exacerbated the issues created by #1, #2 and #3 above.
So Why Are Interest Rates Increasing?
To reduce the amount of money lenders are losing and try to stay profitable (don’t forget: banks exist to earn a profit), they have no choice but to reduce the number of new loans and refinance loans. The only viable (and legal) way to do this is to increase their mortgage interest rates and reduce the amount of time they are willing to lock their rates. This is likely to continue until the larger economic impacts from the COVID-19 outbreak begin to subside.
The COVID-19 pandemic is creating a great deal of uncertainty in many industries, including real estate. If you are contemplating buying a home, selling a home, or simply want to stay current on what’s happening in real estate in South Central Pennsylvania, we invite you to use this site to stay up-to-date with the latest information to help you find some clarity. The Jeremy Ganse Team is available to help answer any questions and guide you in the right direction. We will get through this, together.
Visit our COVID-19 FAQs page for helpful information regarding the impact of the virus on our local community. We will be updating the page as new information is available.