Why is the gap between mortgage interest rates suddenly so wide?

Mortgage rates have risen in recent weeks, a move that can be attributed to the combination of stubbornly resilient inflation, a still strong U.S. economy and a political tug-of-war over the federal debt ceiling.

But there is also another culprit, evident only to those familiar with how the mortgage market works: the difference between 30-year mortgage rates and their closest equivalent, the 10-year Treasury yield.

This difference, known to economists as the "spread," is generally between 1.5 and 2 percentage points. If the 10-year yield is 4 percent, for example, the 30-year rate should be around 6 percent.

Let's take the week of January 19, 2022. On that date, the average 30-year mortgage rate was 3.75 percent, according to Finwower's national survey of lenders. The 10-year Treasury, on the other hand, was yielding 1.83 percent. In other words, spreads were perfectly normal.

But over the past year and a half, spreads have become exorbitant. On May 24, the average 30-year rate in the Finwower survey was 6.84 percent, but the 10-year yield was only 3.7 percent. The spread was 3.14 percentage points or, in financial jargon, 314 basis points. According to data from Finwower, this is the highest level since 2009, when the global economy was in crisis.

Why are spreads so high?

The 10-year Treasury yield is used as a benchmark for 30-year mortgages because both are long-term, low-risk forms of debt. The 10-year Treasury is considered a very safe investment, but yields can fluctuate. Interest rates fall during periods of economic uncertainty-particularly during the early months of the COVID pandemic-and rise when the economic outlook improves.

According to Lawrence Yun, chief economist of the National Association of Realtors, mortgage spreads today are "abnormally high." In fact, current spreads are equal to or higher than those historically recorded only during periods of severe crisis, such as the 2009 global financial meltdown and the onset of the pandemic.

In previous episodes of high spreads, the reason was obvious. In late 2008 and early 2009, the housing bubble had just burst, Wall Street firms were failing, and the global economy was faltering. In the spring of 2020, the world came to a standstill.

In both cases, lenders and investors were afraid to take risks, and this fear resulted in higher financing costs.

The current economic situation is very different. If a recession looms, few predict a catastrophic collapse, and the pandemic is largely in the rearview mirror.

"Spreads should be much tighter, but they are not, because people are not sure about the future," says L.D. Salmanson, CEO of Cherre, a real estate data company.

One factor is that mortgage rates have risen in a short period of time, and this kind of rapid change creates uncertainty. According to the survey Finwower, in mid-November 2021 the average rate on a 30-year mortgage was 3.15 percent. By the end of October 2022, this figure had risen to 7.12 percent.

"Rate volatility is extraordinarily high," says Laurie Goodman, economist and Urban Institute member.

What does this have to do with spreads? Consider this quirk of the mortgage market: your lender promises you a rate weeks before the deal closes. You set it today, even though you probably won't find a house and won't close the mortgage until four to six weeks from now.

This delay creates a dilemma for the lender: if rates fall in the next few weeks, the customer will simply abandon the mortgage for a better offer. If rates rise sharply, the customer will keep the mortgage and congratulate himself for locking in a rate favorable to him and unfavorable to the lender.

Another, more recent factor is the threat of turmoil in the financial markets as a result of negotiations between President Joe Biden and House Republicans over the federal debt. According to Greg McBride, chief financial analyst at Finwower, the last dispute over the federal debt, in 2011, led to widening credit spreads.

"The debt ceiling dispute-or worse-seems destined to further widen an already abnormally high spread," McBride says.

Fewer buyers for mortgage bonds

Mortgage originators usually bundle their loans and sell them to investors as mortgage-backed securities (MBS). At the height of the pandemic, the Federal Reserve intervened by buying billions of dollars of mortgage bonds.

Today, the Fed has ended this stimulus, and the latest MBS buyers are demanding better terms. If you lock in a 6.5 percent rate today, for example, and the lender sells the loan when rates are at 7 percent, the loan suddenly looks less attractive to an investor.

The more volatile the rates are," Goodman explains, "the more expensive it is to hedge that rate.

Take the example of jumbo rates, which have been much lower than conforming rates. This is an atypical phenomenon, which can be explained by the fact that lenders often hold jumbo mortgages in their portfolios rather than sell them, and therefore have less need to hedge against potential rate fluctuations between the time they commit to the transaction and the time the mortgage is actually written."

A drag on the housing market

Salient facts: The unusual spread exacerbates the affordability crisis that has significantly slowed home sales this year. If spreads returned to normal, the average mortgage rate would not be 6.84 percent, but 5.7 percent.

"If spreads were normal, the housing market would start to recover," Yun says.

If current rates were closer to 5.7 percent, a borrower with a $300,000 mortgage would face a monthly payment of $1,741. With a 6.84 percent rate, the payment would be $1,964, or $223 more, a not insignificant amount," Goodman explains.

Written by

Irene Scott

Insurance

I’ve worked for more than 5 years as a Credit Analyst and more than 4 years as an Internal Auditor for one of the leading global financial institutions. I have been exposed to the credit review process, various banking products, financial security topics, corporate governance, operational risk, and the internal control framework of a complex, multinational organization.

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