Why Mortgage Rates Are Rising

The answer has to do with U.S. bonds.

The U.S. government is considered the safest institution in the world.

It has the strongest economy. The backing of the U.S. taxpayer. And the strongest military.

Lend your money to the U.S. government and you’ll get paid back. Uncle Sam has never missed an interest payment or failed to pay back your principal.

That’s why U.S. bond yields are considered the “risk-free” rate.

The Argentinian government, on the other hand, has defaulted 9 times since its independence in 1816. It’s also needed 21 International Monetary Fund (IMF) relief packages since 1956. And has a long history of political turmoil and corruption.

So if both the U.S. and Argentine governments were offering interest rates of 3% on a 5-year bond, you’d always choose to give your money to the U.S.

Why? Because the U.S. government has the better track record. It’s “safer.”

Therefore, in order for Argentina to “win” you over and get your money, it would need to offer a higher interest rate to compensate you for the risk of lending them the money – known as the risk premium.

Right now, U.S. 10-year bonds have a yield of 2.8%. Meaning you’ll get paid 2.8% per year in interest for 10 years on however much you lend the government – i.e. You are buying a bond. Then they’ll pay you back the principal after year 10.

Argentinian 10-year bonds have a yield of 49.7%. Meaning investors are demanding a 46.9% risk premium (49.7% - 2.8%) versus lending to the U.S. government. That’s how much risk is embedded in Argentina.

That’s how nervous investors are about Argentina’s ability to pay investors their money back after 10 years.

Any person, company, country or entity that’s looking to borrow will have some form of risk premium relative to the U.S. government.

What does that have to do with mortgages?

Well, there’s a risk premium lending to individual people too.

Banks are looking for yield. Just like the rest of us.

They have the option of buying U.S. bonds. Or lending money to homebuyers. (Among other places: like companies, etc.).

Therefore, banks assess the risk premium needed to offset lending to you vs. lending to the U.S. government.

So the bank has to make a decision whether to lend money to the U.S. government or the homebuyer.

They calculate the risk premium based on your income. A probability of you losing your job. Your assets. Liabilities. Credit score. Etc.

So as the Federal Reserve has raised interest rates… The 10-year U.S. Treasury yield is moving up alongside it.

Since banks use the 10-year U.S. Treasury yield as a proxy for risk… the risk premium on individuals goes up too.

(Source: St. Louis Fed)

Banks went from offering new homeowners 2.80% fixed rate interest mortgages to now asking for 5%. We haven’t seen above 5% yields since 2011.

This means new homeowners’ mortgage payments have gone up almost 80% in just the past few months. 

New homeowners looking to buy a $500,000 house now have to pay an additional $700/month on their mortgage due to the higher rates. 

How high mortgage rates will go will depend on how high the Federal Reserve raises its rates.

But the knock-on effects are many.

For starters, that $700/month prices out new prospective homebuyers in many neighborhoods. They simply can no longer afford as much “house.”

About 56% of Americans can’t afford a $1,000 emergency expense. So assumingly, they can’t afford an extra $700/month either.

Or if they do pay up for a house, their disposable income goes down.

For example, that $700/month can no longer go to paying for a vacation. Which means airlines and hotels lose out on bookings. Less bookings equals less revenue. Which forces them to cut back on their suppliers. Those suppliers then have to adjust their supply/demand as a function of the airlines and hotels cutting back. And on it goes.

This applies on a personal level too.

Less disposable income means those prospective homebuyers might eat out once a week versus twice a week. Or cut back on going to the movies. Or settle for chicken instead of steak at the grocery store. Or any activity. Which is less money for those businesses. Those businesses make less revenue. And then they have to account for that lower demand and revenue.

Demand will slow either way. Across the board. Which means GDP will contract.

But back to mortgage rates.

Mortgage rates follow the yield on U.S. Treasury bonds. Because Treasury bonds are considered risk-free.

The higher the yields on U.S. Treasury bonds… the higher mortgage rates go.

It’s simply the risk premium that banks need to get compensated for. In other words: How much riskier would it be to lend you money versus the U.S. government?

After all… you’re not the government.

Good investing,

Lance & Mike

Mighty Invest

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