| Mortgage interest rates are the single-most important | | | | is the 10-year Treasury Note. Treasury Notes earn a |
| factor determining the borrowing power of a potential | | | | fixed rate of interest every six months until maturity |
| house buyer. When rates are very low, a borrower | | | | issued in terms of 2, 5, and 10 years. The 10-year |
| can service a large amount of debt with a relatively | | | | Treasury Note is a close approximation to mortgage |
| small payment, and when interest rates are very high, | | | | loans because most fixed-rate mortgages are paid off |
| a borrower can service a small amount of debt with a | | | | before the 30 year maturity with 7 years being a |
| relatively large payment. | | | | typical payoff timeframe. |
| Mortgage interest rates are determined by market | | | | The difference in yield between a 10-year Treasury |
| forces where investors in mortgages and | | | | Note and a 30-day Treasury Bill is a measure of |
| mortgage-backed securities bid for these assets. The | | | | investor expectation of inflation, and the difference |
| rate of return demanded by these investors | | | | between the yield on a 10-year Treasury Note and the |
| determines the interest rate the originating lender will | | | | prevailing market mortgage interest rate is a measure |
| have to charge in order to sell the loan in the | | | | of the risk premium. |
| secondary market. Some lenders still hold mortgages in | | | | Inflation reduces the buying power of money over |
| their own investment portfolio, but these mortgages | | | | time, and if investors must wait a long period of time to |
| and mortgage rates are subject to the same supply | | | | be repaid, as is the case in a home mortgage, they will |
| and demand pressures generated by the secondary | | | | be receiving dollars that have less value than the ones |
| mortgage market. | | | | they provided when the loan was originated. Investors |
| Mortgage interest rates are determined by investor | | | | demand compensation to offset the corrosive effect |
| demands for risk adjusted return on their investment. | | | | of inflation. This is the inflation premium. |
| The return investors demand is determined by three | | | | The risk premium is the added interest investors |
| primary factors: the riskless rate of return, the inflation | | | | demand to compensate them for the possibility the |
| premium and the risk premium. | | | | investment may not perform as planned. Investors |
| The riskless rate of return is the return an investor | | | | know exactly how much they will get if they invest in |
| could obtain in an investment like a short-term | | | | Treasury Notes, but they do not know exactly what |
| Treasury Bill. Treasury Bills range in duration from a | | | | they will get back if they invest in residential home |
| few days to as long as 26 weeks. Due to their short | | | | mortgages or the investment vehicles created from |
| duration, Treasury Bills contain little if any allowance for | | | | them. This uncertainty of return causes them to ask |
| inflation. A close approximation to this rate is the | | | | for a rate higher than that of Treasury Notes. This |
| Federal Funds Rate controlled by the Federal Reserve. | | | | additional compensation is the risk premium. |
| It is one of the reasons this activities of the Federal | | | | Thus, mortgage interest rates are a combination of the |
| Reserve are watched so closely by investors. | | | | riskless rate of return, the risk premium and the inflation |
| The closest risk-free approximation to mortgage loans | | | | premium. |