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How Interest Rates are Determined for Mortgage Loans

By Khary Reynolds | January 4, 2011

There are generally two types of mortgage loans, Fixed Rate Mortgages and Adjustable Rate Mortgages. However, there are many different variations of these two loan types. Learning the basics of mortgages can help reduce confusion, fear, and even save the potential home buyer tens of thousands of dollars.

Regardless of whether you are a homeowner or a real estate investor, interest rates are affected by a variety of economic factors that can have a huge influence on current rates. It is important that you understand these factors in order to decide on obtaining a Fixed Rate or Adjustable Rate Mortgage to purchase a home or to refinance an existing loan.

Freddie Mac and Fannie Mae loans

Freddie Mac and Fannie Mae loans

Generally, mortgages are originated by Banks, Credit Unions, or Mortgage Brokers. Amongst fierce competition, these lenders constantly compete against one another in order to obtain a stronghold within a given region or national marketplace. Lenders compete based upon interest rates, service fees, and customer service, but it is the spread on interest rates and service fees that contribute to the profitability of the lending institution. Given the risks of most funded loans, many lending institutions do not even keep the loan on the books. They simply sell the loan on the secondary mortgage market at a discount.

Secondary markets are generally known as aggregators, but loan originators and lending companies can also act as aggregators as well. Generally, these companies pool together mortgages from different borrowers and build secure accounts called mortgage backed securities. Mortgage backed securities are bonds backed by a pool of mortgages and then sold off to other investors. Mortgage backed securities are priced then priced and sold off to investors. The pricing determines how much can be spent on newly originated loans by lenders.

Understanding mortgages

Understanding mortgages helps you and the industry

This in turn affects the interest rates charged to consumers on new refinance loans. If this sounds a bit confusing, it actually can be, but the principle is pretty simple - your actual loan will likely end up owned and managed by a firm you never heard of. But more importantly for the overall economy, if something goes wrong across the breadth of a market, those securities become highly volatile and sometimes even worthless, ergo our current economic situation. But that is a subject for another article.

Hence, mortgage backed securities are held in the form of Bank Investments, Insurance Companies, Pension Funds, Private Hedge Funds, Foreign Investors, and Government Real Estate affiliates: Freddie Mac and Fannie Mae. The level of demand for mortgage backed securities determines their price in the market. Investors looking for good returns will regularly compare these securities with other investments that provide income such as Government and Corporate Bonds.

In order to trace the source of interest rates charged for mortgage loans, you must follow the chain from borrower to securities investors. The mortgage loan process ends with an investor purchasing mortgage backed securities from a secondary mortgage dealer. It is therefore safe to assume that the investor, to a large extent determines the interest rates charged to clients.

Clearing prices for mortgage backed securities are originated in the free market for any willing investor. These prices run up and down within the mortgage industry and finally dictate the interest rates given to credible borrowers.

The Federal Reserve also plays a role in interest rate increases. They normally set current short term interest rates for securities such as the yield on US Treasury 10 year bonds. The bonds market normally reacts according to the Federal Government’s control of short term interest rates. It is common knowledge that interest rates on 30 year Mortgages are related to Treasury 10 year bonds. Speculators therefore keenly watch the yield on the Treasury bond and compare it with Federal Monetary policies in order to forecast how interest rates are likely to perform in future.

What it all means to you

Nebulous terms and what it all means to you - courtesy Goals for Americans

Overall, there are numerous factors that come into play when determining interest rates for mortgage loans. If you take the time to conduct your due diligence and learn about the economic factors that affect interest rates, you will be well on your way to acquiring a mortgage loan that is right for you. And what's more, the better educated people become about how these systems work, helps individuals, even homeowners in general, avoid the pitfalls of ownership and investment.

If every investor had listened carefully to the eHow tutorial below before the investment world put tens of billions in mortgage backed securities before the meltdown, America would be in far better shape. The video also gives you more information about how these "instruments" work.

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