Are 3% Mortgage Rates Coming Back?

Mortgage rates have stalled and stammered, an odd result given that they were expected to be far higher by now. In fact, as of late May, it's not unfair to wonder if rates might actually slip back into the 3 percent range.

Go back to last year and the general predictions were that mortgage rates in 2014 would hit 5 percent and go up from there.

"Mortgage interest rates," said the National Association of Realtors in November, "are expected to trend upward and reach 5.4 by the end of next year.

“We expect mortgage rates will increase above five percent in 2014 and then increase further to 5.5 percent by the end of 2015," said the Mortgage Bankers Association back in October.

Indeed, the MBA is sticking with its forecast. As of May 19th it suggests that rates will hit 4.5 percent in the second quarter, 4.9 percent in the third quarter and 5 percent by the end of the year. The prediction for 2015 has been revised downward with mortgage rates reaching 5.3 percent by mid-year.

However, if we turn from our tea leaves for a minute what's actually happening is different.

The Cash Surplus

It turns out that the world is awash in money. The biggest problem faced by banks today -- at least that we know of -- is that vaults are too small. Maury Harris, managing director and chief U.S. economist at UBS, says banks have more than $2 trillion in "excess" cash.

The vast stockpile of cash held by lenders accounts for a very interesting problem, especially if you're a borrower. It's tough to raise rates when so many lenders in so many places must do something with their cash. The competition to lend money is enormous, not only because lenders have vast sums of unused capital but also because lending activity is in the dumper.

Let's divide the mortgage marketplace into two parts, loans used to buy homes -- purchase money mortgages and mortgages created to refinance old loans.

According to the MBA, financing to buy homes is expected to pick up this year by 3.8 percent. That's a pretty tepid result but compared to refinancing it's an absolute gold rush.

Why? Refinancing activity, said the mortgage bankers in January, is expected to fall around 60 percent this year.

A lot of cash is one reason mortgage rates are down, less demand for financing is another. The result, as Freddie Mac said last week, is that mortgages are near seven-month lows.

Could Mortgage Rates Actually Fall Below Four Percent?

There's nothing mystical about four percent, it's just a marker that's easy for humans to track, so yes if rates continue on their merry retreat we could dip below four percent. Here's why:

Lenders produce loans in the same way that butchers produce sausage, they grind them out. Lenders have fixed costs so when they churn out a lot of loans the cost per mortgage goes down and lenders make good money. When volumes fall then fixed costs per loan increase and lender profits decline.

For instance, in the first quarter the Federal Deposit Insurance Corporation (FDIC) reports that "income from the sale, securitization and servicing of mortgages was $4.0 billion (53.6 percent) lower than a year ago. One- to four-family residential real estate loans originated and intended for sale were $323.6 billion (70.6 percent) lower than in the first quarter of 2013."

Lenders are thus caught in a difficult squeeze. On one side loan volumes are down so profits have declined -- the Mortgage Bankers Association says "independent mortgage banks and mortgage subsidiaries of chartered banks made an average profit of $1,242 on each loan they originated in 2013, down from $2,199 per loan in 2012."

Seen another way, the FDIC says that in the first quarter "mortgage originations have fallen sharply, and mortgage revenue has declined by almost one-half."

On the other side mortgage rates are falling, meaning that lenders have to fight to get what business is out there and competition also pushes down margins. The result? Less employment in the mortgage field and maybe fewer lenders willing to make home loans.

"As mortgage and trading activity slows," says The Wall Street Journal, "banks are likely to accelerate programs to slash expenses further after laying off thousands who specialized in home loans in the past year."

What's worse for lenders than less mortgage volume and smaller profits? Idle capital. Capital sitting in a vault loses value as buying power declines with inflation. Capital sitting in a vault does not earn interest. Given the choice of small profits or outright losses those small profits can seem mighty tempting for lenders, good news for mortgage borrowers looking for low rates and a broad range of financing options.

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