Real mortage interest rates can be calculated as the difference between nominal mortage interest rates and the 10-year Treasury Bond interest rate. Although nominal interest rates have ranged from 3% to 16%, the real, after expected inflation, interest rates are remarkably consistent, averaging just 1.7% and ranging between 1.3% and 2.1% in 70% of the last 52 years. The peak real rate was 3.0% in 1982 following the unexpectedly high and remaining high nominal rates of the prior 4 years.

Banks, mortgage-backed securities investors and mortgage borrowers all take risks when they complete mortgage transactions. Lenders are betting that their present and future borrowing interest rates are and will be low enough to fund their mortgages at a profit. Each lender locks in funding commitments for a reasonable share of the loan life and counts on the consistency of interest rates over the business cycle to fund the remaining portion. Lenders that experience a mismatch put their stockholders’ equity at risk and face bankruptcy. Investors in mortgage-backed securities are subject to valuation change risks throughout the period in which they are invested. Most such investors hold diversified portfolios of mortgages (region, amount, riskiness, urban vs suburban vs rural) and non-mortgage assets to ensure that any investment decision will not be too damaging.

Fixed-rate mortgage borrowers are betting that inflation will not fall too much lower than the expected inflation rates when they borrowed. If so, they will be paying back the mortgage in higher real value dollars than expected. If inflation and mortgage rates drop by more than 2%, most borrowers will seek to refinance their mortgages at the new, lower market rates, paying another round of closing costs for this privilege. Fixed rate borrowers are also hoping that inflation will be higher than the expected inflation rates at the time they borrowed, allowing them to pay back their debt with cheaper real dollars. Mortgage originators do not generally have the legal right to “call” the debt and require a change in the rates and terms as many commercial lenders and bond issuers do.

The “good news” is that the US mortgage market is very efficient and the real interest rate premium for borrowing to own a home is just 2% more than what the US government pays for borrowing. Borrowers face interest rate change risks, especially being caught with a high interest rate mortgage when inflation rates fall if they are unable to refinance.

The market has been tested through 7 business cycles and held up very well. The “Great Recession” exposed excessive risk taking by mortgage originators and funders. They lost money and many went out of business. Riskier mortgages are rarely issued today, and government regulations provide some added protection against any future overreach.

For higher income households that itemize deduction on their federal tax returns, the nominal interest rate paid is a tax-deductible offset to earned income. These individuals typically pay 22%, 24% or 34% marginal tax rates. A 5% nominal tax rate can provide a 1%, 1.25% or 1.65% reduction in the effective interest rate, thereby making the 2% real mortgage rate less than 1%. Higher income households can benefit greatly from this tax benefit.

https://fred.stlouisfed.org/series/MORTGAGE30US

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