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Why Low Mortgage Rates Mean Higher Cost Mortgages

September 23rd, 2010 Leave a comment Go to comments

Personal finance is very often interfered with by well meaning government policy. There is perhaps no more interference by government than the housing market. I don’t want to talk about all of the ways that the housing market is distorted (it would be quite a long post), instead I will focus today on just one distortion: very low mortgage rates.

How We Got Here

U.S Housing mortgage rates are near all time lows, as of this writing they are below 4.5% for a 30 year fixed mortgage. The reason why the rates are so low, is due to interference by the U.S Federal Reserve in the Mortgage Backed Security (MBS) market and in the U.S. Government Treasury Bond market. In a normal market, the Federal Reserve sets short term interest rate policy by expanding or contracting the money available to banks. Since we are in unusual times,  the Federal Reserve has taken additional steps to buy MBS and U.S Government debt.

Buying debt increases the price, while depressing the interest rate on the bonds. The yield on U.S debt is near all time lows. Mortgage rates are in large part tied to the interest rates on U.S Debt. The Federal Reserve expansionist policy has lead to very low mortgage rates.

How The Banks Respond

Banks write mortgages by borrowing short term and lending long term. The difference in this spread is the basis for their profit. The question is, would a bank want to lend money out at 4.5% or lower for 30 years? No they wouldn’t because they understand that the near zero interest rates don’t last forever.

So, how do you get a mortgage if banks don’t want to write them? Well, chances are you will be getting a loan held or insured by Freddie Mac or Fannie Mae. According this this NY Times article, 98% of the new mortgages are processed by these Federal agencies.

Banks have problems of their own. Their existing mortgages that they hold have credit problems, and at the same time the U.S Congress has toughened up the reserve requirements for banks which lowers the amount of money available to be lent.

Therefore, given the state of the market, banks are content to make money originating and servicing mortgage loans instead of on the loan itself. So, all the higher fees that the banks are charging to originate loans is the main way they make money today.

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