Pass-Through Rate (Mortgage-Backed Securities) - Explained
What is the Pass-Through Rate?
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Table of ContentsWhat is the Pass-Through Rate?How does the Pass-Through Rate of Interest on a Mortgage Backed Securities Work?Pass-Through Rate vs. Interest RateFannie Mae and Freddie Mac vs. Pass-Through RateThe Bottom Line
What is the Pass-Through Rate?
The pass-through rate is the interest amount paid to investors by a mortgage-backed security issuer once all fees and costs to do with servicing the investment have been paid. This type of rate, also known as coupon rate for an MBS, functions as an investment return for investors who choose to invest in the securities. The rate is lower compared to the interest rate realized on the individual securities. First, the amount of money given to investors goes through the underlying mortgages payments, then to the paying agent, and finally to the investor.
How does the Pass-Through Rate of Interest on a Mortgage Backed Securities Work?
In many cases, it is possible to project investors realized amount of return from the pass-through rate generation. However, like any other given investment, you should expect the possibility of unanticipated factors coming up, and likely to influence the generated net interests actual amount. A variable or floating rate in the mortgages that back the security, rather than a fixed rate, is likely to shift the average rate of the interest. It will, in turn, affect the returns level. Because of this, most investors usually consider any possible changes in the interest rate, over the security's life and factor into the projected pass-through rate. By doing so, they are able to know if the security's return is worth the underlying mortgages risk.
Pass-Through Rate vs. Interest Rate
Generally, the pass-through rate the borrower pays on the mortgages he or she uses to back the security is usually below the average interest rate. Note that there are some fees that are deducted from the interest. The charges include securities transaction-related fees and investment guarantees charges. These types of fees are set up as a percentage for interest earned. However, it is sometimes charged at a flat rate as stipulated in the terms and conditions that govern securities issuance.
Fannie Mae and Freddie Mac vs. Pass-Through Rate
To ensure liquidity, affordability, and stability in the mortgage market, Congress came up with two organizations known as Fannie Mae and Freddie Mac. The role of these organizations is to make liquidity available for those banks, mortgage, savings, and loan companies that offer loans for financing homes. What Fannie Mae and Freddie Mac do is to buy mortgages from lenders. They then hold the mortgages in their investment portfolios that are likely to be sold. To engage in additional lending, the lenders make use of the money raised from selling mortgages. The reason why these organizations make purchases are to help those investors buying apartment buildings and individuals purchasing homes have a constant mortgage money supply.
The Bottom Line
Generally, those institutions that underwrite mortgages usually prepare and issue this type of financial instrument. So, provided the economy continues to be stable, the risk associated with investing in this security will remain low compared to other investment options. Also, the return from the pass-through rate may be seen to match the degree of risk involved.