Why You're Spending Too Much on Your Mortgage

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With millions of homeowners underwater on their mortgages, not everyone has been able to take advantage of the rock-bottom rates on home loans. But for those who have been able to refinance, low rates have proven to be extremely useful, slashing monthly mortgage payments and freeing up valuable cash to spend on other needs.

Yet as much as some homeowners have been able to save on their mortgages, some believe that they should be paying even less than they are currently. The reason has to do with an obscure relationship between home-loan rates and the mortgage-backed securities market, but the result is that homeowners may be missing out -- while lenders book better profits than they deserve.

Why mortgage-backed bonds matter
It's hard to complain about where mortgage rates are right now. Currently, 30-year rates are below 4% after having come close to the 7% mark as recently as mid-2007. Enterprising homeowners have had many opportunities to lock in lower rates, and some have actually refinanced on multiple occasions in recent years.

But with the Federal Reserve doing everything it can to keep rates low, some believe that not all of the Fed's efforts are making it through to homeowners. A recent Wall Street Journal article explained how the mortgage-backed bond market has seen even sharper drops than retail mortgage rates.

Here's how it works: Most banks that offer mortgage loans end up selling them to entities like Fannie Mae and Freddie Mac, which then package them with similar loans to create mortgage-backed securities. Lately, demand for those securities has been red-hot, as investors snap up shares of mortgage REITs Annaly Capital (NYSE: NLY  ) and American Capital Agency (Nasdaq: AGNC  ) , which in turn buy those bonds. That has pushed the interest rates investors are willing to accept on those bonds way down -- further down, in fact, than the rates homeowners pay have dropped.

The spread between what borrowers pay and what investors accept represents profit for banks and other intermediaries. With that spread at roughly twice its normal level, money that would otherwise go to homeowners -- or to the mortgage REITs -- is getting siphoned off by those intermediaries. And even though the amounts involved aren't huge -- half a percentage point amounts to less than $100 per month on a $350,000 mortgage -- they are significant in the aggregate.

Who's profiting?
Banks and mortgage lenders can certainly argue that anything extra they're getting from mortgage refinancings now is fair compensation for the losses they've suffered in the recent past. With Wells Fargo (NYSE: WFC  ) , Bank of America (NYSE: BAC  ) , and JPMorgan Chase (NYSE: JPM  ) among the participants in the recent $26 billion settlement of questionable foreclosure practices, they're clearly interested in whatever ways they can find to recoup lost profits and boost their financial health.

But in my view, this is simply another example of how the housing-related markets aren't functioning the way they should. Just as government refinancing programs took away the focus from the true problem of underwater mortgages forcing people to stay put when they'd prefer to sell out and start over, so too are divergent trends in the primary mortgage industry versus the mortgage-securities market creating some undesirable results.

What to do
From your perspective as a homeowner, what this means is that it's more important than ever to shop around to try to find the best deals. One criticism has been that large institutions have priced smaller banks and mortgage lenders out of the market, using economies of scale to build market share. But even as lending standards have gotten tighter, you need to remember that refinancing still represents a very profitable opportunity for your lender -- one in which you should share the benefits.

Getting your housing budget under control is just one way in which you need to plan for your long-term financial goals. Another is putting together the right portfolio. To get some smart investment ideas, check out The Motley Fool's latest special report. We highlight three smart stock picks for retirement investors, and we won't charge you anything at all for it -- but it won't be around forever, so read it today while it's still available.

Fool contributor Dan Caplinger cut his mortgage costs to the bone awhile back. You can follow him on Twitter here. He doesn't own shares of the companies mentioned in this article. The Motley Fool owns shares of Bank of America, Wells Fargo, JPMorgan Chase, and Annaly Capital, and has created a covered strangle position on Wells Fargo. Motley Fool newsletter services have recommended buying shares of Annaly Capital. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy puts a roof over your head.

Read/Post Comments (5) | Recommend This Article (5)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On February 23, 2012, at 9:58 AM, mrschnider wrote:

    One fact you are not aware of is that banks get paid relatively the same when they sell their mortgage to one of the (thirteen or so) mortgage servicers. There used to be hundreds of mortgage servicers pooling loans and selling them off to F&F but now because of costs the vast majority have pulled out of the business.

    You need to speak to an employee within the capital markets dept of a bank and they can explain to you about their hedging practices and about "expiring rate locks". Your beliefs are based upon intuition, there is much for you to learn on such things such as who profits when rates are volatile.

  • Report this Comment On February 23, 2012, at 4:42 PM, 5000monkey wrote:

    Not to mention the over regulation on the mortgage industry has made mortgage rates higher for all borrowers. By about .25% this mean instead of pay 3.5% today your getting your loans at 3.75%

    I'm a licensed originator myself and I used to average about 2% in fees on any loan I closed, I'd make more on some and less on others, but often times if I could lock a loan on a good day I could pass that savings on to my clients. Now I make closer to 3% on all loans because I'm mandated to make the same on all clients. This could go n and get a lot more complicated but government regulation has removed my ability to pay for my clients costs and have over all made all loans more expensive.

  • Report this Comment On February 23, 2012, at 6:15 PM, TMFPennyWise wrote:

    Dan, thanks for the interesting article.

    Also, Dan, in case underwater homeowners paying high rates aren't aware, there is some relief for many of them.

    The government HARP program is available to most owners whose mortgages are owned by Freddie or Fannie. These refinances are made often without an appraisal, very little paperwork, no income ceiling and we didn't have to pay any application fees.

    We used this program to refinance through Chase Mortgage, the original issuer, 2 rentals we own and I encourage anyone who is underwater to check out the HARP FAQs online.

    Apparently this is a program designed for the ordinary homeowner and very few of them have taken advantage.

  • Report this Comment On February 23, 2012, at 6:28 PM, sailrmac wrote:

    What you are really seeing is greater costs of mortgage origination and packaging (people not paying their mortgages, settling lawsuits, greater government regulation, etc), as well as the results of less competition in the industry doubling the spread. This in turn is passed on to the consumer via higher mortgage rates than what they otherwise would have been. If not for the advent and popularity of mREIT's as an investment, and the demand that is creating, rates would be even higher. Sorry, the higher spreads between mortgage rates and MBS rates are not the anomoly but more likely the rule going forward.

    Moral hazard, unintended side effects, protection, whatever you want to call it, it results in less competition, higher spreads and higher rates for everyone.

    It's similiar to after the blow up of Enron and Worldcom. It resulted in greater regulation which still exists and has costs and those costs continue to be reflected in prices to the consumer.

    Note this is not meant as a political comment. The regulation may be very worthwhile but we need to realize that there is always a cost.

  • Report this Comment On February 23, 2012, at 11:29 PM, imaphule2 wrote:

    I know this will sound really odd to most people but...

    I'm saving money (keeping it in treasuries/cash) until I have enough to pay cash for a house. Unfortunately, I'm in the Bay Area where the median price is around half a million so I have a ways to go. Luckily, the longer I wait the lower prices seem to go...

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