Few people understand how mortgage rates are set. While there are many influences on interest rates, it basically all comes down to what is called a Mortgage-Backed Security or MBS. A MBS is defined as an asset-backed security or debt obligation that represents a claim on the cash flows from mortgage loans, most commonly on residential property.
Banks or lending institutes grant loans to individuals to buy homes. Those mortgage loans are then purchased by other banks or mortgage companies. These loans are assembled into pools by government agencies or government sponsored enterprises such as Fannie Mae or Freddie Mac. The buying of these loans also frees up banks to loan more money out for mortgages. Once these pools of money are assembled, they are turned into securities due to being secured by the government thus giving them the name Mortgage-Backed Security.
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MBS or mortgage-backed securities are divided into subtypes. These subtypes include pass-through mortgage-backed securities such as residential mortgage-backed securities and commercial mortgage-backed securities; collateralized mortgage obligation, and stripped mortgage-backed securities.
Within a pool of mortgage backed securities there are also other variations that indicate how the borrower will pay their loan back. They include:
o Prime - Conforming mortgages with full documentation such as verification of income and a strong credit score.
o AltA- A prime borrower but one who is borrowing in a non-conforming way, often with lower documentation.
o Subprime - Borrowers with weaker credit scores or no verification of income or assets.
Mortgage-backed securities are often a favorable investment for investors and the more favorable to investors the higher they sell for, which in turn helps mortgage rates go down. This is due to giving the banks back more money to operate with.
There are various reasons that the MBS is then priced. Investors want to know how quickly a loan will be paid back as some loans are worth more if paid back quickly while others will go down in value if repayment is made to soon. Other factors that can affect the price of a mortgage bond are inflation, economic growth which increases housing turnover in the market, regulatory risk which includes changes in tax laws, demographic trends and unemployment.
Mortgage-backed securities are also considered low risk. Why?
1. Most banks or lending agencies will only loan to those who are credit-worthy.
2. Securities are issued by organizations such as Fannie Mae, Freddie Mac and Ginnie Mae have a guarantee that exists with the US Federal Government through lines of credit. Fannie Mae and Freddie Mac also require private mortgage insurance on loans in which the borrower provides a down payment that is less than 20% of the property value.
3. Pooling mortgages helps reduce risk or spreads the risk out.
4. If a property owner defaults on their loan, their property remains as collateral which helps offer some payback to the bank.
While all of this language may seem complicated, understanding some of the basics behind home loans can help you see how your mortgage loan's interest rate is determined. If you are waiting for the right time to buy based on a few economic factors, know that it is best to talk to a mortgage professional or consultant about timing rather than guessing on your own.
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