An epic decline in knowledge about why mortgage rates may appear to have fallen by near record amounts recently


An epic decline in knowledge about why mortgage rates may appear to have fallen by near record amounts recently

When rates jump from some of the largest amounts on record to the highest levels in over a decade, it sets us up for equally impressive corrections when the underlying bond market finally finds its footing. This happened last week in a big way after the Fed’s announcement.

From Tuesday morning to Wednesday afternoon, rates fell more than any other day since we started keeping daily records in 2009. In many cases, this was equivalent to a drop of 0.375% in terms of fixed compliant rates over 30 years, even though the average was “only” 0.25%.

Today’s drop from yesterday is “only” 0.19%, but it’s still one of the top 5 biggest overnight declines we’ve recorded. Again, some scenarios at some lenders see a drop of up to 0.375%.

What about the difference between these instances of 0.375% and our average of 0.19%? First of all, one is an average, and not all scenarios improved that much. Second, and more importantly, it has to do with this potentially confusing point I’ve raised almost daily for the past few weeks about “redemptions” between rates being much lower than normal.

Since this is a somewhat complex topic depending on your level of familiarity, let’s take a moment to break it down.

Mortgage rates: initial cost vs. cost over time

Mortgages have 2 costs whether you can see both or not. One of these costs is obvious. It has to do with the interest rate. The higher the rate, the higher this cost. You will pay it over time in monthly installments.

The other cost is paid (or credited) up front. This may take the form of origination fees, “points” (i.e. discount points), underwriting fees or other lender charges – all costs required by the lender to obtain the ready.

There is never just one interest rate available to you. Although not all lenders offer a range of rate options available, they could if they wished. Higher rates would have lower upfront costs and vice versa. Go for a high enough rate and the loan is profitable enough for the lender to actually pay their normal upfront costs for you. This is where a “no closing cost” loan becomes possible (but keep in mind that definitions differ on what this really means. Some lenders refer to lender related fees while others will leave you raise the rate high enough to pay other costs as well, like title/escrow/etc).

The ability to offset initial costs with higher rates depends on the value placed on mortgages by the financial market. Remember that these loans will eventually become bonds traded by investors.

Investor appetite for certain loans at certain rates may change. For example, if rates are very high, investors expect homeowners to jump at the first opportunity to refinance at a lower rate. This investor will be cautious about buying too many of these higher rate loans because if they refinance too soon, the lender loses profits.

In fact, an investor may even have paid so much for a higher rate loan that they WILL LOSE money if that loan is refinanced within the first few months. This is one of the reasons why a mortgage lender may be hit with a penalty from the investor in the event of an EPO or “prepayment”.

With all that in mind, now is one of those times when investors are generally wary of paying too much for higher-rate loans. This not only limits the amount of upfront costs that can be absorbed by switching to a higher tariff, but also creates uneven gaps between adjacent tariffs in upfront costs.

The reason for this is pretty esoteric unless you’re a student of the mortgage bond (MBS or “mortgage-backed securities”) market, but it has to do with the rules that govern which loans can go to which MBS.

We’re almost out of the arcane woods, but stick with me for the last part. It’s the scariest and most esoteric.

MBS are available in different coupons. A coupon is a fare. It tells investors how much an MBS will pay like any other interest rate or bond yield. Different MBS coupons have different prices. The combination of price and coupon can be inserted into an equation to determine the actual rate of return for an investor.

Generally, an investor pays more for a higher coupon. They give up more money upfront in exchange for the right to receive higher payouts over time.

MBS coupons are distributed in increments of 0.5% (i.e. 4.0, 4.5, 5.0, etc.). A given coupon is like a bucket that can hold loans that are between 0.25% and 1.125% higher than the coupon. That was the confusing part. If you understood that, you are free at home.

In other words, if your loan has a rate of 6.125%, it may end up in an MBS of 5.0. But a loan with a rate of 6.25% should go into a coupon of 5.5 MBS because it is more than 1.125% higher than the coupon of 5.0.

Now let’s get to the thesis. Remember how we said investors were a little concerned that higher rate loans were paying off too quickly? The catch is that investors don’t think about individual loans as much as MBS coupons. In this environment where rates have risen so much that the expectation of a cap/correction is growing, lenders are placing a higher than normal relative value on the LOWER of two adjacent MBS coupons.

In other words, they would rather have 5.0s than 5.5s. They prefer to have 4.5s than 5.0s. This preference remains intact for all coupons currently applicable to available mortgage rates.

THE ESSENTIAL: What this ultimately means is that a mortgage rate in the 5.0 range has more relative value than one in the 5.5 range . The valuation difference is so pronounced right now that most lenders have LOWER upfront costs on a 6.125% rate compared to a 6.25% rate. Same story at 5.625% vs 5.75%. This means that the overall cost to buy your rate from 6.25% to 5.625% is about the lowest possible.

The bottom line even lower: the bond market and other interest rates haven’t really moved as much as these record high days for mortgage rates suggest. And depending on the lender, your specific rate quote might not have gone down as much, but for some borrowers who were quoted certain rates at certain lenders, you might see a huge change from yesterday or from last Tuesday .


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