Did you ever wonder where the money comes from to make mortgage loans? Or, how the interest rates are determined? As complex as lending can become, most of the time it’s pretty straight-forward. When the systems are operating as designed, it works as follows.
And the money goes round & round
The Federal National Mortgage Association (Fannie Mae) and theFederal Home Loan Mortgage Corporation (Freddie Mac) are semi-privatized financial institutions that buy mortgages and bundle them into financial securities and treat them like bonds. Then they sell the mortgage-backed securities to investors.
It’s those investor funds which keep money flowing to the mortgage finance system. After you get a mortgage, the lender sells the loan on the secondary market, probably to Fannie or Freddie. By selling the mortgage, the lender gets its money back quickly so it can lend the money again, to another mortgage borrower.
The secondary market encourages mortgage lenders to lend more funds to more buyers, because the lender’s money is returned quickly, rather than being tied up as you gradually repay it over the years. When the lender sells your mortgage, the lender gets the full amount of the loan back immediately, with a profit, which can then be reinvested.
Meanwhile, investors, predominantly “institutional investors,” such as employee retirement funds, buy these securities because they offer stable payments for the members of their institution.
It’s these investors in the secondary market who collectively determine the interest rate of your mortgage loan. Your lender offers you an interest rate that investors on the secondary market are willing to buy.
As with stock and bond markets, prices and yields on the secondary market move up and down. When the economy is on an upswing, investors demand higher yields on mortgage bonds, trying to keep pace with the stock market. In turn, this forces lenders to raise mortgage rates. In a market downturn, the paucity of investment opportunities means investors will accept lower interest rates which then tend to drop for home buyers.
Next Issue: How does the Federal Reserve Bank impact interest rates?