This article dives into how interest rates are structured, how lenders set the interest rate on a mortgage, and how rates affect property values.

What’s an interest rate, anyway

Mortgage interest rates shift on a daily basis, sometimes down and sometimes (more often over the past two years) up. Mortgage rates are further classified as either:

  • consumer mortgages; or
  • commercial mortgages.

For a real estate agent, forecasting where interest rates will be at any given time is difficult, but not impossible. First, an understanding of the various components that make up an interest rate — and what influences each of those components — is necessary.

Commercial banks are the delivery network for moving U.S. dollars to individuals and businesses necessary to buy things efficiently. To distribute money, banks first borrow money, euphemistically called savings deposits. The borrowed funds are further lent to members of the public, the bank tacking on an interest rate margin to cover their cost of operations, risk of losses, and a profit.

Apart from the cost-plus approach for bank lending, how does an individual lender arrive at an interest rate when investing in a mortgage, directly with property owners or indirectly via the mortgage-backed bond (MBB) market?

Mortgage rates of interest are made up of:

  • a base or “real” rate of return, say, at the 10-year Treasury Note rate less the rate of anticipated inflation (CPI);
  • the rate of inflation;
  • a default premium rate which varies based on the loan-to-value (LTV) ratio, credit risk of the borrower not paying, and recessionary versus recovery asset value expectations; and
  • the expected future rise in mortgage rates generally triggered by factors other than inflation, such as anticipated greater real rates of return on future investment opportunities.

Fundamentally, the setting of mortgage rates is tied to the treasury bond market, as are capitalization rates for evaluating income producing real estate. For example, FRM rates move in tandem with the 10-year Treasury Note rate. The interest rate for a 10-yr T note is comprised of two figures; a real rate of return of, say, 2%, plus the expected long-term consumer inflation rate of, say, 2%. Thus, a market rate of 4% for the T-note investment which, significantly, is free of any risk of loss.

Not so for mortgages. They have a history of a rate of default requiring foreclosure on the secured property. To cover this risk of loss on a mortgage, a premium rate is added to the base rate comprised of a real return and the consumer inflation rate.  PMI/MIP play a role in limiting this rise but does not eliminate it.

Historically, the default risk premium spread between the 10-yr T-Note rate and the 30-yr FRM rate hovers around 1.5% (the spread is far greater for cap rates).

However, since the 2022 return of FRMs funding the bond market, the risk premium spread has been significantly higher — closer to 3.0%. This generous spread indicates lenders sense the need to pad their risk premiums in anticipation of future rate increases and an uptick in mortgage defaults — and losses on foreclosures.

On individual mortgages, risk premiums tend to be higher when the LTV is low. Critically, these low LTV mortgage lenders are covered from most losses by mortgage default insurance for which the borrower additionally pays a premium of nearly 1%. For example, a borrower putting down a 20% down payment will qualify for a lower risk premium — and thus a lower total interest rate charge while totally avoiding paying mortgage insurance (PMI/MIP) — than a borrower with a lesser down payment.

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The bond market is involved

Interest rates on long-term debt obligations, such as the 30-year FRM, reflect bond market investor perceptions about the level of success the Fed will achieve in their control of consumer inflation. When the Fed appears to be succeeding in normalizing excess consumer inflation, bond market investors tend to accept lower yields. The result is FRM rates taper to reflect a lowering of the consumer inflation (CPI) rate.

In other words, when the Fed’s inflation fight becomes aggressive, investors pile into bonds as a safe haven and long-term bond rates decline. In contrast, when the Fed allows inflation to rise beyond its target rate, investors shy away from bonds to take advantage of more profit-based opportunities — and bond rates rise.

When bond prices are rising, interest rates decline. When bond prices decline, interest rates rise; an inverse relationship as takes place in reporting price and earnings for income producing real estate. Here, the stock market is a bit deceptive. When stock prices rise, the figure the market uses to state earnings also rises in tandem, so everything is positive. To do so, they use the reciprocal of percentage earning rates to report earnings, called the P/E ratio.

Most recently, we saw this money market dynamic appear in the fourth quarter (Q4) of 2023; the Consumer Price Index (CPI) began to consistently normalize, signaling to bond market investors the need to edge back into bonds as the economy is slowing. FRM rates began to decline as a result.

Editor’s note — Mortgage-backed bond (MBB) purchases are a helpful Fed tool to stimulate the economy during fragile economic times, as lower interest rates and a higher money supply encourage consumers to take out loans, and banks to lend. This includes auto loans, personal loans and, yes, mortgage loans.

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ARM rates are very different

Any increase in the Federal funds rate directly causes rates to increase in short-term money lending such as investments in Treasury bills, certificates of deposits (CDs) and repurchase agreements (RPs). In the real estate market, movement in the federal funds rate brings on movements in ARM indices. In turn, this triggers agreed-to adjustments in the note rate and payment schedules for existing ARMs.

A Fed decision to increase short-term rates is spurred by the Fed’s perception that higher consumer price inflation (CPI) looms in the immediate future due to a developing excessive demand for goods and services and a tightening labor market which rewards jobholders with more income to spend. A case for businesses that “your income is my income.”

Or, as during 2022-2023, the Fed increases its Federal funds rate to counter inflation which in 2020-2021 was permitted to run dangerously hot due to abundant fiscal and monetary stimulus needed to fully fill the economic abyss of the pandemic period.

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The Fed tightens credit by increasing short-term rates. This directly raises the cost of borrowing for banks. In turn businesses, governments and buyers of all sorts who finance big-ticket consumer items such as cars and appliances on credit, or finance home renovation simply pay more interest. On tightening credit, the availability of money is limited by charging more interest, slowing all types of purchases (spending). This axiomatically slows the economy down, decreasing the level of price inflation and slowing (or stopping) job and wage growth.

Thus, all interest rates work like a tax on income to take money out of or put money in the hands of consumers — especially owners of property encumbered by ARMs.

Editor’s note — FRM rates are not directly affected by the Federal funds rate. Instead, FRM rates are tied to 10-year Treasury notes, controlled by the bond market.

Interest rates in 2024 and beyond

During short periods of time, watch for FRM mortgage interest rates to continue to work their way lower, followed by ARM rates, as the Fed demonstrates inflation (and job growth) are under control. Expect the FRM rate to dip through 2025 followed by a long-term upward trend, which, in 2013, introduced a half-cycle of some 30 years of rising rates for all types of borrowing.

Interest rates rise and fall in a cycle. In 2024, we are in the midst of a long rising trend, which began in late 2012 (interrupted briefly by 2020’s pandemic interference). This will include around three decades of rising interest rates, slowly but continually reducing buyer purchasing power. Pricing of assets will not provide the profits on resale as took place in the years before 2013.

The last few interest rate cycles have included:

  • a 27-year downward trend in rates (1922-1949);
  • a 32-year uptrend (1949-1982); and
  • a 30-year downward trend lasting through 2012.

While interest rates will vary up or down in the short term, firsttuesday anticipates today’s rising trend to continue through roughly 2040.

Watch for FRM rates to resume their upward path once the economy begins to recover from the 2024 mid-period of our real estate recession, likely around 2026.

What’s an agent to do with this information?

As rates continue to increase, agents need to learn quickly to cope with a reversal from prior decades into an unfamiliar set of investment and pricing challenges. These include different income multiplier/capitalization rates, long-term holding periods before profits can be taken, and Due-On Sale lender interference with an owner’s ability to sell.

The key lesson to remember for consideration in the upcoming years is this: real estate is a collectible to be properly priced when purchased and held for its inherent rental income value, not resale profits. Those who buy property for speculative gain on, say, a flip, will see little success in profits taking. Today’s forward conditions are like those for investments in the real estate market from 1950 to 1980, when mortgage rates moved slowly, steadily upward until they exceeded 18%.

The next peak in rates, whether or not they reach past heights, will likely take another two decades to arrive. But the past half-cycle period of steadily decreasing interest rates with rent increases limited to a ceiling of CPI increases, mathematically produced ever increasing prices and profits which are now fully behind us.

Looking forward, what is needed is astute property management which keeps gross rental income maxed out, operating costs at a minimum, and fixed rate mortgage financing to build up net operating income (NOI) for taking profits in the future – an activity called sweat equity.