The loan that people turn to the most when buying their home is a mortgage. Mortgages are secured loans that use the borrower’s property as collateral. Mortgages form the primary component of the housing market aside from home prices. The one key factor of a mortgage that makes it attractive or repulsive to home buyers is the mortgage rates. There is a lot of confusion about what determines mortgages interest rates. A common question is “Who sets mortgage rates?” The question implies that someone arbitrarily decrees mortgage rates, which is not the case at all.

Lenders determine which applicants are approved for a loan and on what terms. The actual interest rate of mortgages is determined by the secondary mortgage market. This is where stocks and bonds collateralized by mortgages (known as mortgage-backed securities) are sold. This market is very large and very liquid, meaning these securities are either already in cash or easily convertible into cash.

The market works like this: say a lender like a bank makes a new mortgage loan to a homeowner. This newly originated mortgage is then sold by the bank to either Fannie Mae (FNMA, the Federal National Mortgage Association) or Freddie Mac (FHLMC, the Federal Home Loan Mortgage Corporation). The bank does this to collect fees from the sale and to secure itself against the risk of default. These two government-sponsored enterprises then package the mortgage into a mortgage-backed security. The MBS, in turn, is sold to investors. Increasing investor demand drives up mortgage rates because lenders now have to take the price of mortgage-backed securities into account when calculating loans.

Are mortgage rates likely to fall? No, in fact they are likely to rise. The Federal Reserve will stop buying mortgage-backed securities on March 31, 2010. That would lead to mortgage rates skyrocketing as the market compensates for the increased risk. Mortgage rates are likely to skyrocket anyway as increasing foreclosures make the banks nervous, irrespective of the price of mortgage-backed securities.