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Chrisman's Corner: Basic Bond Math for Mortgages

As JMAC’s brokers know, the overwhelming percentage of home loans are put into securities “backed” by those mortgages, meaning that the monthly payments that borrowers make flow through to investors such as banks, insurance companies, and even the Federal Reserve. But how are loans priced – is the bond market just like the stock market?

Mortgages back mortgage-backed securities (MBS), which are bonds that compete in the market with other bonds for investment dollars. In order for investors to make money they need to buy low and sell high, which is a best guess based upon their judgement. If many investors believe a price of an investment will go up then they will bid for the investment and create high demand, which increases prices. If they feel the opposite will occur and that prices will decline, they will sell their investment, creating high supply, lowering prices.

Since MBS have an interest rate and yield on investment, if a borrower has a 30 year mortgage at 4% rate, when you pay the 4% payment that becomes a rate of return for someone’s investment – usually 3 or 3.50% is “passed through.”

But remember that bonds and MBS have a price and yield. For example, a bond worth $100 and pays 5 percent per year can earn $5 ever year to whoever owns it. In order to be competitive in the market, instead of paying $100 for that bond you would offer $83 so the $5 interest is a 6 percent return, paying a lower price to get a higher return.

If a local bank can provide a 4 percent interest on the $100 bond, no one would sell the bond paying 5 percent return since they would lose money. Instead, the bond would need to sell for $125 with the $5 annual interest payment, which equates to 4%.

That all being said, our brokers know that if economic news is positive, and the economy is thought to be doing well, then bonds and MBS prices will decline and rates will increase. If the economic news is bad then bond prices will increase and rates will drop.