Risk-Based Pricing Is Part of the Equation

People Standing in a Line Means There is Demand...and Prices Go Up

I?m not talking about risk-based pricing. (See my article on Why You Might Not Be Able To Get a 5% Mortgage for more information on that.) Risk based pricing?which is normal on all loans now, including conforming and FHA?refers to the increases in pricing you take depending on the loan-to-value (LTV) of the home or your credit scores. If your home is worth $200,000, the rate you get on a $180,000 loan (90% LTV) loan wouldn?t be as good as the rate you?d get on a $160,000 (80% LTV), and the rate on a $120,000 (60% LTV) would be even better. Additionally, the pricing isn?t as good for somebody with a 660 credit score versus a 720 score. There are now actually differences at 620, 660, 680, 700, 720, and 740.

Rather than risk-based pricing, what I would like to discuss in this post is if you take the same borrower, and the same house, why can he get 5.375% one week, and 5.75% the next? Why do these rates change? It simply boils down to Wall Street, and what investors are willing to pay for mortgage paper. This is one of the major reasons we will not see a 4.5% rate, like some officials are talking about. (See my article Why 4.5% Mortgages More Myth Than Reality? for more details.)

Mortgage Rates Are Strongly Connected to the Stock Market

Most of you probably have a good idea about how stocks work. You buy shares of a company at a given price, and hopefully the company is turning a profit and growing, and the stocks go up in value, at which point you can sell them and make a profit. But, these days, the markets here and abroad are generally decreasing in value…not increasing. Sure, there are some companies individually that aren?t hurting as much as others, or there are the occasional good days in the market, but anybody who has an IRA, 401k, or stock options has lost a lot of money in their investments recently.

What else can you do with your money? Sure, you have the low-risk options like savings accounts, certificates of deposit (CDs), or you can try your luck on futures. However,  mortgages bonds (a bond secured by a mortgage on a property) are a good fixed investment. Generally the yields on mortgage bonds are better than a savings account or CD, but you can?t make as much as you could on a good run of a stock.  In the late 1990s, when the stock market was doing nothing but flying upward, everybody was buying stocks, and investors were not buying lower-return options, like mortgage bonds, because they were all making double-digit returns on their stocks. But now, when all stocks seem to be slipping downward, making even a modest return, like you would on mortgage bonds, isn?t a bad investment.

Supply and Demand Drive Interest Rates

So mortgage bonds, like stocks, and just about everything else in a free-market society, work on supply and demand. When demand goes up, so do prices. And when prices on mortgage bonds go up, rates go down. The first big drop in rates we?ve had recently came just before Thanksgiving 2008. The federal government said they were going to buy billions of dollars of mortgage bonds. So, investors, reacting to this news, started buying up mortgage bonds, and, all of a sudden?BAM!?mortgage rates went way down. The Dow, the NASDAQ, and the S&P 500 continued to slide downward, along with all of our retirement funds, and investors tried to move toward a safer return, like mortgage bonds.

Right now, I believe the only thing preventing bonds from going even higher, and rates even lower, is that investors are still generally skittish regarding anything related to mortgages because of all of the recent foreclosures. That, coupled with bank and lender over-cautiousness, will keep rates form dipping ridiculously low.  We did see a nice little drop in rates Thursday the 5th and Friday the 6th, but not to the lows seen in January.