How mortgage interest rates work (and why they're currently out of whack)

0:01NPR

0:10There is a mystery in the mortgage market. The long-running relationship between mortgage interest rates and 10-year treasury bonds, 10-year loans to the U.S. government, has changed. That's right. In normal times, mortgage interest rates are usually a little less than two percentage points higher than what you would get on a 10-year treasury. So let's say treasuries are paying 4%, you would expect a mortgage interest rate of a little less than 6%. But over the last couple of years, that relationship has broken down. One of our listeners, Matt Kazoulis, noticed this and asked us about it. I'd noticed that they had been above 2%, and historically speaking, that is very high.

0:57Matt, we are on the case. We're going to figure out what is happening here. This is The Indicator from Planet Money. I'm Waylon Wong. And I'm Darian Woods. Today on the show, how mortgage interest rates work and why they're currently out of whack with new borrowers footing the bill.

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2:50Get 10 % off your first order site-wide with code OseaGlow at OseaMalibu.com. Bill Emmons worked at the Federal Reserve Bank of St. Louis for a long time and now teaches at Washington University in St. Louis. He ran us through the basic economics of how mortgage interest rates get set, starting with the wholesale market for lending. Think of an analogy, it's like gasoline. We don't actually take gasoline out of the ground. Oil comes out of the ground, so there's a market for oil, and then it has to be processed. So there are also refineries that take the oil and refine it into gasoline and other products.

3:29And then the gasoline has to go into another market. It goes into a gas station. So there's a retail component of it. There's three parts. First, the crude oil. That's the 10-year treasury bond. This is the important benchmark guiding the entire mortgage system. The 10-year treasury bonds dictate more or less how much it costs banks to borrow money. Then there are the refiners. That's the wholesale mortgage market. And thirdly, the gas station, the retail banks who actually lend you your mortgage. That second part of the chain, the wholesale mortgage market, adds maybe one percentage point to the mortgage interest rate.

4:07And the reason for this little bit on top is risk. Bill says the middlemen are worried about mortgage borrowers paying back the mortgage too early. That typically happens when interest rates have fallen, and so that's less attractive to an investor. So actually that gets priced in. The fact that borrowers may prepay their loans, pay them back before the 30-year term, is a bad thing. That's a risk that investors need compensation for. So imagine there's a mortgage provider that's lending to someone for 30 years with a 7 % mortgage rate. They'd be hoping that the borrower keeps dutifully paying that 7 % every year.

4:46But when interest rates around the country fall, that borrower is tempted to refinance. And they can borrow at, say, 5 % from somebody else and pay back the original mortgage provider. And that is bad news for the original mortgage provider. They're not getting all those future high payments that they expected to get. And that is what that extra percentage point or so is. It's the mortgage borrower, everyday people like you and me, compensating the mortgage lender for taking us on. knowing that we might seize an opportunity and end our 30-year mortgage early. It's almost like insurance. It is exactly.

5:22It is exactly insurance, yes. Or an expensive gift in the case of a potential divorce in the future. Now you're weaving a whole tale. I'm weaving some fan fiction about the bank and the borrower, the beauty and the beast. I would read that. And adding another bit to the mortgage interest rate is that third link in the chain, the retail market, you know, the banks you get your mortgage from. Bill says the banks might usually add maybe another percentage point max, and that helps pay for the tellers and the bank branches and the websites and advertising and any financial risk for the bank. So on average, the difference between the 30-year mortgage and the 10-year treasury rate would be something like one to two percentage points.

6:06And it's been above that recently. Right now, the spread is actually around 2.6 percentage points, A rough back-of-the-envelope calculation suggests that someone borrowing$300 ,000 might be about$1 ,500 a year worse off because of this. Bill thinks the reason for this extra cost started a couple of years ago, mostly in the wholesale market, you know, the oil refinance, to go back to our analogy. So this is at a time when the economy was coming out of COVID, but still a lot of uncertainty about what's happening. The Fed is raising interest rates, a lot of uncertainty about where interest rates will be.

6:43And so the risk premiums that you could identify that large-scale lenders, investors, were demanding, those were definitely moving up in the 22 into 23 period. So as interest rates were climbing a couple of years ago, the wholesale market didn't know whether this would tank the economy. Maybe housing prices were going to fall. Maybe interest rates would come crashing back down again. Or maybe there'd be a different scenario where interest rates would stay high for a long time. I mean, it might seem a bit certain now, but if you think back to that time, everything was very uncertain. And so the wholesaler wanted even more of a buffer to lend money.

7:25About a year ago, that fear and loathing in the wholesale market calmed down. The feared recession wasn't emerging, and the path forward with inflation slowly cooling and and rate cuts likely at some point appeared more predictable. But just as the wholesale market was starting to get back to normal, Bill says that retail banks then went haywire. Hmm, a little over a year ago. What's happening? SVB, the 16th largest bank in the U.S., is now the biggest American bank to fail since the 2008 financial crisis. Yeah, you've got it, Waylon. Silicon Valley Bank and all the other bank failures. First Republic Bank has become the second largest bank failure in U.S.

8:07history. Bill says he suspects this rash of failures spooked retail banks. A lot of evidence now that's accumulated that bankers generally were very much shaken by that. Their sensitivity to risk seems to have increased. And so one of the ways that happens is that they are competing less aggressively. They're not pricing as aggressively as before. I don't know about you, Waylon. Have you noticed fewer mailers from banks begging you to please take a mortgage out at a low interest rate? Actually, I still get them. They go right in the recycling bin. Yeah, yeah. I mean, the junk mail will always come through.

8:46But they're not offering great rates. They claim the great rates, but then you look at them and they're not amazing. And, you know, Bill says this is backed up from what he's seeing in surveys of banks. Those tremors in early 2023 seem to have increased the risk sensitivity or the risk aversion of many lenders. Bill is seeing retail banks require an extra cut on top of their usual slice because he thinks they've become less competitive with each other to drive down interest rates to attract more customers. The best thinking in this area, I think, is that it's more strategic and that many players are watching other players.

9:23And so it almost becomes, even without outright collusion, it becomes a sort of a coordinated response. Bill suggests that banks watch each other. And then when none of the banks blink, the mortgage interest rates stay high at the expense of regular mortgage borrowers. So would you like to see customers shopping around for their mortgages more? Of course, yes. I know from personal experience, it's not fun to shop around. It's tedious. It's time-consuming. Maybe many people assume because there are so many lenders, it must be competitive. But in fact, you know, the evidence is it's not totally competitive.

9:59Now with the Fed's interest rate cuts on the horizon, mortgage interest rates are coming down. But the oversized spread that our listener Matt wrote in about is still there. Bill says that could mean there's hope for interest rates to come down even further. There's every reason to believe, as long as the banking system continues to be safe and sound, that these competitive forces do play out over time. And so you would expect this elevated spread to normalize. Maylon, I choose optimism for these borrowers. Yes, me too. We need a happy ending on your fanfic. You're saying this is fanfiction. This is serious, investigative nonfiction.

10:42This episode was produced by Angel Correares with engineering by Cole Takasugi Chernepin. It was fact-checked by Cyril Juarez. Cake and Cannon edits the show and The Indicator is a production of NPR.

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