That Superlow Mortgage Rate? It Could Be Even Lower

Interest rates have been plummeting, but the cost of taking out a mortgage hasn’t fallen as fast.

Falling rates are usually a boon to the housing market, since that typically lowers the interest rates that lenders offer on mortgages. Borrowers can then buy homes or refinance their existing mortgages at a lower monthly cost. But they haven’t been feeling the full benefit of the recent rate swoon, one reason the housing market has remained cool over the past year.

Melissa Cohn, a mortgage broker and banker at Family First Funding LLC in New York, said she has been trying to temper clients’ expectations in recent months about how low of a mortgage rate is available to them.

Mortgage rates are closely linked to yields on 10-year Treasury notes. Since the end of June, the Treasury yield has fallen about 0.4 percentage point, but the average mortgage rate has dropped just 0.16 percentage point. The gap between the two rates is near its highest in more than seven years, according to an analysis by Dow Jones Market Data.

The average 30-year fixed rate for a mortgage this week is 3.57%, according to mortgage company Freddie Mac. That is among the lowest average rates this year, but it has bounced up and down in recent months.

Mortgage executives, traders and investors tend to watch the spread between the 10-year Treasury yield and the 30-year mortgage rate as a barometer of the mortgage market’s health.

The spread blew out as the market imploded in 2008, when Treasury yields plummeted but lenders were slower to adjust mortgage rates.

More recently, the difference has signaled that borrowers’ relatively strong appetite for mortgages is outpacing the industry’s ability to make them. Many lenders scaled back last year as mortgage demand dropped, so the current demand is stretching their capacity.

“When the spreads widen, the banks make more money and the borrowers don’t get as low of a rate as they otherwise would have,” said Walt Schmidt, who oversees mortgage strategies at FTN Financial, a broker dealer.

The relationship can quickly flip if lenders have to compete more for business, he said, giving consumers the upper hand. That happened a few weeks ago when Treasury rates jumped and the gap with mortgage rates narrowed.

The current gap indicates that mortgage lenders don’t have to lower the rates they offer as much to win business. Many say they are seeing bumper demand for mortgages, even without dropping the rates they offer in lockstep with Treasury yields. Though home sales have been lackluster, many borrowers who took out mortgages at higher rates last year have been refinancing.

When lenders charge higher rates, they typically earn more on each loan, a trend that could boost third-quarter earnings. The major banks with large mortgage businesses, including JPMorgan Chase & Co. and Wells Fargo & Co., are scheduled to report next week.

Mortgage rates rose throughout much of last year, shrinking the refinancing demand, and many lenders had to trim their operations and lay off staff. Even though rates have reversed course this year, so far they have been reluctant to hire again en masse.

“If rates stay low, they will start hiring people, but they can’t do that overnight, nor do they want to,” said John Kerschner, head of U.S. securitized products at Janus Henderson Investors. “What they do is they basically manage that supply by not lowering their rates nearly as much.“

Another factor that is keeping mortgage rates relatively high compared with Treasury yields: Investors are demanding more income on securities backed by these mortgages. When rates fall, more people refinance their homes and pay off their existing mortgages, which means the investors in mortgage-backed securities lose part of their income stream.

To make up for that, investors tend to demand higher returns on the mortgage securities. That, in turn, slows the fall in mortgage rates because investors can make more when rates are higher.