Fil and I were talking last night, and neither of us really had a solid understanding of how mortgages work. We knew that the Federal Interest Rate was involved, we knew that Freddie Mac/Fannie Mae were involved, and obviously that banks were involved. But, how they all work together is, to say the least, confusing.

Based on what I’ve read, I’m trying to sketch out a “plain english” description of how it all works. In doing some reading, I’ve already learned at least 10 things that I thought I understood but didn’t. Please fill in the comments with corrections, but this is how I think it all kinda works (not that I’ve ever had a mortgage):

When you get a mortgage, you go to a bank and give them a bunch of information about yourself, and the house, and whatever, and they come up with a rate. I’ve seen enough LendingTree.com commercials to understand that much. So, my questions already were:
1) Where does the money come from? Is it just money sitting in the bank, money that was put there by joe american’s savings account and jane american’s checking account?
2) Where does the interest rate come from? Is it related to the interest rate that “The Fed” raises and lowers from time to time?

1) Where does the money come from? Based on some reading at howstuffworks.com, it seems that the money you are lending does in fact come from the bank. At this stage in the game, none of the complexity of what Freddie Mac/Fannie Mae do is in the picture. The bank buys the house for you with their money, and you owe the money back to the bank based on the terms you set up in the mortgage.

Banks have to meet some federal requirements that, in a nutshell state that they can’t loan out all of the money they have. They always need to have 10% of their total cash locked up, either in their own vault, or stored at the federal reserve. Banks that have more than 10% locked up are said to have “excess reserves.” So, all banks have restrictions on how much they can lend.

2) Where does the interest rate come from?
First off, here we have to revisit question #1 – where the money comes from. Let’s say the bank is loaning out so much money that they’re starting to cut into that whole 10% reserve requirement. What they will do then is borrow money from a bank with a reserve surplus so that they can keep their reserve at 10%.

So, now Bank A borrowed from Bank B. Bank B obviously doesn’t do this for free – this is a loan and they want to make interest on it. What interest rate does Bank A pay Bank B? That’s where the Federal interest rate (the one that gets raised/lowered on the news) comes in. That is not the rate at which the government lends money to banks (even though that’s what the name looks like), but rather it is this rate – the rate at which one bank can borrow from another bank.

I then wondered “how can they regulate that?” but I’ll get to that answer later.

So, to some extent the interest rate you get from the bank, aside from being determined by the obvious (your credit score, property value, amount you’re borrowing, etc) is also influenced by how much the bank is borrowing from other banks to keep their head above that 10% mark.

But it gets more complicated…
As it turns out, there’s more going on with banks than just borrowing money from other banks. Banks make money off your loans, and because of that, they want to have as many loans as they can. Because of that 10% requirement, they’re going to need a lot of cash on hand in order to issue a lot of loans. One way they can do that is by selling your loan to someone else. This is where Freddie Mac/Fannie Mae come into the picture.

These companies are interesting because, although they are private and don’t have any federal funding, they were created by Congress (one in the 30’s, one in the 70’s). Freddie Mac’s website cleared up some of my questions about them as a government entity – they’re publicly-traded, profitable, and pay taxes. These companies buy your loan from a bank, and then sell bonds backed by your mortgage, at lower rates.

So, for a super-simple example, let’s say the bank gives you a loan at 6%. That means they give you $250,000, and in return you agree to pay it back plus 6% interest. Freddie Mac would then give the bank $250,000 at 5.5% interest. So, the bank is now making .5% from your loan, and now it has it’s $250,000 back which it can loan to other people. Freddie Mac then creates bonds out of your loan, which it might issue at 5% interest. Then people on the open market can buy those bonds, which are relatively safe because they trust Freddie Mac to ensure you’re going to pay your loan on time. In summary:
– You get a loan
– Bank gets a cut, and gets their cash back so they can keep on lending
– Freddie Mac makes money from bonds, which are ultimately your debt that it’s responsible for.

At this juncture I think it’s appropriate to revisit how “The Fed” controls the interest rates between banks. It’s not a direct rule where they say “Bank B must loan Bank A money at x%” – it’s more subtle than that. What the Fed is doing is setting a “target” interest rate. They say “I want Bank B loaning Bank A money at x%” and then, they go off and do what they can in the market to get that interest rate to equal their target. If they want to lower the interest rate, they’ll start buying bonds. If they want to raise it, they’ll sell bonds.

And how are government bonds related to the interest rate between banks? When the federal reserve sells a bond (or other security), that means a bunch of people are giving the government money in exchange. That money is coming out of the countries’ banks, where people keep money, and going to the federal government. When money starts leaving the banks, that means the banks have less money to lend out. It also means banks are going to have to borrow more, which is going to make it more expensive to borrow. Interest rates between banks go up.

[That part was the hardest for me to understand, but reading this publication (PDF) from the Federal Reserve helped me get my head around it. They didn’t really write that concept in plain english… they wrote it like this:

Conversely, sales of securities decrease the quantity of Federal Reserve balances because the Federal Reserve extinguishes balances when it debits the account of the purchaser’s depository institution at the Federal Reserve.

I did my best to translate it, and hopefully did so accurately.]

So, let’s say for example they want to raise interest rates .5%. They can start issuing government bonds for sale in the market. Government bonds are pretty much considered a “sure thing.” There is next to no risk in buying a government bond, for example a traditional savings bond. If you can buy a government bond and get 5% back, or a private bond for 5%, the government bond would be preferable because of how safe it is. So, these bonds are attractive and people buy them. That mechanism allows the government to impact interest rates because they’re taking money out of the banking system.

That’s what I’ve learned so far. Maybe it is helpful to others, maybe not. Let me know if you find anything that’s inaccurate. I know I’ve left some parts out intentionally, because it could really bubble out of control if everything’s included (this interest rate has dramatic effects on almost every aspect of our economy, including employment statistics). There are also other types of loans, including direct government loans, but I was trying to stick to the most common case.