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How Bonds Affect Mortgage Rates

4-minute read

There are a few obvious factors that influence how much you’ll pay in interest on your mortgage loan. You probably know that your down payment, credit score and loan type all affect your final interest rate. However, there are also many hidden factors that influence market interest rates as a whole. One of those factors is the bond market.

We’ll take a look at how bond rates influence mortgage rates. We’ll also take a look at which types of mortgages reflect the effects of the bond market on their mortgage rates.

Strong Bond Market Means Lower Mortgage Rates

Bonds are long-term, low-risk investment products. Corporations can issue private bonds but Treasury bonds issued by the federal government are much more well known. When you buy a bond, you give the government a set amount of money per bond. The bond then accrues two types of interest: fixed interest and inflation interest.

The fixed interest on a savings bond follows the same model as the fixed interest on a mortgage loan. Every year on May 1 and November 1, the U.S. Treasury announces a fixed rate for new loans. You’ll earn that percentage of interest on the loan if you buy one before the next interest rate announcement. Your bond also accumulates additional interest to keep up with inflation rates. Once your bond reaches the end of its term, you get your original money back plus whatever the bond gained in interest. You can also buy and sell bonds on the secondary market like stocks.

Bond prices and mortgage interest rates have an inverse relationship with one another. That means that when bonds are more expensive, mortgage rates are lower. The reverse is also true – when bonds are less expensive, mortgage interest rates are higher.

At first glance, this might seem like an illogical correlation. When interest rates are higher, more people will want to buy bonds – why don’t higher interest rates push bond prices up? To understand, let’s look at the supply and demand of the secondary bond market.

Let’s say that you buy a Treasury bond for $1,000 with a 2% annual fixed interest rate. Once you buy that bond, you’re locked into a 2% interest rate until the bond matures. Now, imagine that it’s a year later and interest rates are higher. The same $1,000 bond investment can net you a 3% annual interest rate.

The same year, you need some cash, so you decide to sell your bond. You probably won’t be able to sell your bond for the full $1,000. This is because other investors know that they can get 3% if they invest their $1,000 by buying a bond from the Treasury. The price of your bond will fall to whatever other investors are willing to pay for it. For example, an investor might offer you $900 in cash for your bond. In effect, the price of your bond is lower now because current market rates are higher. Though you can still cash out your bond for $1,000 when it matures, its current liquid value is less than $1,000.

If the Treasury lowers bond rates, the opposite scenario will play out. Imagine the Treasury announces that $1,000 bonds will now have 1% interest rates. Investors know that they’re better off buying your bond than bonds from the Treasury because your bond accrues more interest. With more competition for your bond, you can sell to the highest bidder. The bond you bought for $1,000 might now be worth $1,100 to an investor who wants to hold onto it until it matures. The investor who buys your bond for $1,100 will still receive $1,000 when he sells it. However, right now, it’s worth $1,100 because interest is on the decline and an investor wants to secure his money at a higher rate.

Most mortgage lenders keep their interest rates a bit higher than bond interest rates because they tend to attract similar investors. Both bond investors and real estate investors want their investment to have collateral. When bond prices drop, it means that bond interest rates are on the rise. By extension, this also means that mortgage interest rates rise, too. On the other hand, if the secondary bond market is strong and bond prices are high, it means that bond interest rates are low. This lowers mortgage interest rates.

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Which Mortgages Are Affected By Bonds?

Not every type of mortgage will feel the effect of Treasury bond rates. Bond prices only influence fixed-rate mortgage loans. This is because mortgage lenders only peg fixed interest rates to bond rates. Let’s say you’re considering an adjustable rate mortgage. You’ll need to consider the Federal Reserve’s most recent interest rate decision. You’ll pay less for your mortgage loan if the Federal Reserve decides to cut interest rates on the federal loans available to banks. If federal rates go up, you’ll pay more.

As an individual, you cannot control how the bond market moves. However, you can control which mortgage lender you work with. Compare different lenders and take a look at all of your interest rate options before you choose which company you want to work with. Choose a lender with a solid reputation and affordable rates. You’ll feel the effects of your lender’s customer service team and personal policies much more strongly than the movement of the bond market when you manage your loan.

Summary

Bond prices have an inverse relationship with mortgage interest rates. As bond prices go up, mortgage interest rates go down and vice versa. This is because mortgage lenders tie their interest rates closely to Treasury bond rates. When bond interest rates are high, the bond is less valuable on the secondary market. This causes mortgage interest rates to rise. The value of each bond goes up when bond interest rates fall again. This causes mortgage lenders to lower their rates.

Bond prices only affect fixed-rate mortgage loans. Decisions made by the Federal Reserve affect the prices of ARM loans. Your lender choice is much more influential when it comes to picking the best mortgage loan than bond or Reserve rates.

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