The pass-through rate is the amount of interest, usually referred to as net interest, that the issuer of a mortgage-backed security pays to investors, once all costs and fees associated with servicing the investment have been settled. This rate functions as the return that investors realize by choosing to invest in the securities. The reference to this type of interest rate as a pass-through has to do with the fact that the amount forwarded to the investors passes from the payments on the underlying mortgages, through the pay agent, and ultimately to the investor.
It is important to note that the pass-through rate is always less than the average interest rate that is paid by the borrower on the mortgages used to back the security. This is because various types of fees are deducted from the paid interest. These fees include general management fees for conducting transactions relevant to the securities involved, as well as any type of charges for guarantees associated with the investment itself. Often, these fees are set up as percentages of the interest generated, although in some cases the fees are flat rates that are defined in the terms and conditions governing the issuance of the securities.
The creation of a securitized asset pool that involves the use of mortgages as the backing for the securities is not uncommon. Many institutions that underwrite mortgages will prepare and issue financial instruments of this type. As long as the economy remains stable, the risk associated with investing in this type of security arrangement remains low in comparison to some other investment options, and the return realized as the pass-through rate is highly likely to be considered equitable for the degree of risk involved.
In many situations, it is possible to project the amount of return that an investor will realize from the generation of the pass-through rate. As with any investment, there is the possibility of unanticipated factors arising that may influence the actual amount of net interest that is generated. For example, if the mortgages that back the security carry a variable or floating rate rather than a fixed rate, shifts in the average rate of interest will impact the level of return. For this reason, investors do well to attempt to anticipate any changes in the interest rate over the life of the security, and factor them into the projected pass-through rate. This will help the investor determine if the return on the security is worth the degree of risk associated with the underlying mortgages.