Mortgage-Backed Securities: What They Are and How They Affect Rates
Mortgage-backed securities are bought and sold every day by retail and institutional investors, and while it may not be obvious, these transactions indirectly impact mortgage rates and how much it costs to buy your home.
The buying and selling of mortgage-backed securities can help keep mortgage rates low and allows mortgage banks to provide funding for home loans. We cover how mortgage-backed securities work and how they impact interest rates below.
In this article:
- What are mortgage-backed securities?
- How does a mortgage-backed security work?
- Why MBSs are important to mortgage lending
- How are loans funded by mortgage-backed securities?
- How mortgage-backed securities affect interest rates
What are mortgage-backed securities?
Mortgage backed-securities, or MBSs, are bonds secured by a mortgage or pools of mortgages. Homeowners might assume the principal and interest they pay each month is going to their mortgage company. In most cases, a portion of it is passed on to different investors through a mortgage-backed security, along with the principal and interest from hundreds of other loans pooled together in that MBS.
Most MBSs are issued or guaranteed by the same agencies that you might have heard about when you applied for a mortgage — Fannie Mae and Freddie Mac. These agencies are government-sponsored enterprises that buy and sell mortgages. Ginnie Mae, another MBS agency, is a U.S. government corporation that guarantees the principal and interest payments of loans made by government-approved lenders.
Investors like MBSs because they receive payments of principal and interest just as often as you make your payments: monthly. Most bond pay-outs are semi-annual, so a pool with tens or hundreds of mortgages helps generate monthly cash flow for MBS investors.
How does a mortgage-backed security work?
Every mortgage-backed security starts with a mortgage. So what’s the difference between a mortgage and a mortgage-backed security? When you close on a purchase mortgage, the lender deposits the money in the escrow company’s account to pay the seller, and you make monthly payments of principal and interest to your lender. The legal agreement you sign stating that you’ll pay the loan back is the actual mortgage, and it’s secured by your home, which serves as collateral.
Instead of keeping your mortgage, the bank can pool your loan with several other home loans with similar rates and terms, creating a mortgage-backed security. The MBS can be sold, freeing up funds for the bank to lend to other homebuyers or homeowners.
Why MBSs are important to mortgage lending
Here are a few key reasons why MBSs are critical to the health of the mortgage-lending market:
They help reduce banks’ lending risk. When a home loan defaults, the lender has to worry about the financial loss. Prior to mortgage-backed securities, a bank had to have the funds to cover a default loss, take back the home and sell it again before making another loan. This limited how many loans a bank could close, making it hard for homeowners to get a loan if banks didn’t have the extra lending reserves. Mortgage-backed securities, however, help offset these risks so that banks can continue to make new loans.
When someone defaults on a loan, the bank loses much more than the profit they would’ve received on the loan. When banks take ownership of a home through foreclosure, they incur the costs of holding and maintaining the property, the legal fees associated with the foreclosure and resale costs.
The investment is diversified. A diversified investment means you don’t put all of your financial eggs into one basket. Mortgages present a substantial financial risk to lenders and MBS investors, so it’s critical that they diversify their investments by loan type, size and geography.
As of the first quarter of 2019, the average U.S. mortgage debt per borrower was $202,284, according to Experian, so even a handful of foreclosed loans could result in large losses for mortgage lenders. By selling home loans secured by a mortgage-backed security, lenders reduce their risk, which frees up capital for them to offer more financing to mortgage borrowers.
How are loans funded by mortgage-backed securities?
When you take out a loan, a mortgage-backed security might be involved, depending on the type of loan you choose. Here’s a look at how each loan program factors into MBSs.
Conventional loans. If you have a conventional loan, chances are it’s part of an MBS created or held by Fannie Mae and Freddie Mac in the secondary market. These government-sponsored enterprises help ensure a steady flow of affordable mortgage funds throughout the U.S. housing market.
Government loans. Ginnie Mae guarantees MBSs for government-insured loans. These include loans backed by the Federal Housing Administration (FHA loans); loans guaranteed by the U.S. Department of Veterans Affairs (VA loans); and loans backed by the U.S. Department of Agriculture (USDA loans).
Selling and refinancing keep MBS money flowing. As loans are paid off through new home sales and refinancing, money is freed up, allowing new mortgages to be made. This creates a “liquid” market where there’s a constant supply of new mortgage money entering and leaving the market.
How mortgage-backed securities affect interest rates
MBS are affected by the same types of economic and market factors as bonds, with one exception: they are always trying to guess when you might payoff your current mortgage. That can have an effect on what MBSs investors are willing to buy, which affects the rates offered by mortgage lenders.
What drives mortgage rates up? When lenders raise their rates, homeowners are less likely to refinance because there’s not much benefit. MBS investors don’t want to be stuck with too many loans with low interest rates, so they’ll start looking to buy mortgages with higher rates, which means mortgage lenders will raise their rates to create new pools for investors to buy.
If you look at historical mortgage rates, you’ll find rates rise when the economy is doing well, or inflation is on the rise.
What pushes mortgage rates down? A mortgage rate trends graph reveals when the economy starts to falter, or inflation falls, mortgage rates often start to fall. For MBS investors, that means they get their principal back sooner than they expected, and they’ll start reinvesting that money at lower rates.
So what do they do? They start buying lower-yielding MBSs to generate new income. The more MBSs that investors buy, the lower the rates drop.
What does all of this mean for mortgage borrowers? If you look at a 30-year fixed mortgage rate chart, you’ll see that mortgage prices change constantly. Lenders change their pricing strategies depending on how much money they make or lose from MBS sales — that’s why it’s so important to shop around with multiple lenders for mortgage rates.
If you’re thinking about buying a home or refinancing, check rates frequently, and look for lenders who might be priced more aggressively. The extra work could save you thousands of dollars over the life of your loan.