We talk a lot about how mortgage bonds are the driving force behind mortgage rates, but we never get into the math of it. So, to help our understanding of the subject, let's delve a little deeper. Here's the (very simplified) math behind it:
If you pay $100 today for a $6 annual interest payment over 30 years and then you get your $100 back, you would have earned 6.000% on your money.
But, if you paid $98 today for that same $6 annual interest payment, your rate would have be 6.122%.
If you paid $102 today for that same $6 annual interest payment, your rate would have be 5.882%.
Because the interest rate of a particular bond never changes, we can see how lower price leads to a higher yield, or rate, and vice versa.
This basic math is why mortgage bond prices and mortgage rates move in opposite directions.
Now, the price of mortgage bonds is determined by the demand for them. When demand for mortgage bonds increases, the price for mortgage bonds increases.
- If you paid $102 today for that same $6 annual interest payment, your rate would have be 5.882%.
By contrast, when the demand for mortgage bonds falls, the price for mortgage bonds falls, too.
- But, if you paid $98 today for that same $6 annual interest payment, your rate would have be 6.122%.
And, as we can see in the examples above, as bond prices rise and fall, the relative yields (i.e. rates) of those bonds move in the opposite direction. Lower prices translate into higher rates, and higher prices drive rates down.
For more on how mortgage bonds prices work, check with Google.
