What Makes Mortgage Rates Go Up & Down ?
By James Hussher
As you might already know, mortgage rates changes daily and sometimes
more than once a day. Let's discover why this happens.
There are two main lending markets in the mortgage industry the "primary" and "secondary" lenders. Primary lenders are the banks consumers get loans from. Secondary lenders are the institutions that buy mortgages from banks and then in turn sell bonds called "mortgage-backed securities" to obtain funds to buy those loans from banks, and give banks more money to do more loans. It is a process.
The money used to lend to borrowers essentially comes from investors. Mortgage money comes from many sources, including deposits at banks and brokerages, but most comes from investors through what is collectively known as the "capital markets." This
is where investors interested in purchasing certain kinds of debt instruments - bonds, in this case - come to buy these items.
In order to attract investors, sellers of bonds must compete with one another to sell their product. They do this by offering several varieties of "instruments" with differing configurations of risk and return over given periods of time. These offerings compete with other investments which are reasonably similar in performance, such as US Treasuries, corporate bonds, foreign bonds, and others.
These products must offer a good rate or else the investors will just take their money elsewhere. The demands of these investors plays a considerable role in moving market rates, because investors have literally hundreds of places to put their money. It's a crowded marketplace, with many sellers of various product competing for those investor dollars.
Investors can be fickle too. They might like one product today, and switch from it tomorrow. And the best way to then attract investors to that product is by raising the interest rates.
Mortgage market makers serve not one client, but two: investors, who want the highest possible return on their investments, and the homeowner or homebuyer, who wants the lowest possible interest rate. Simultaneously, rates need to be high enough to attract investors but low enough to attract borrowers.
Mortgages are priced for sale to attract investors who seek fixed income investments. There are many kinds of bonds available, and mortgage rates (yields) rise and fall with those competing investments to a greater or lesser degree.
But how to price them? Fixed mortgage rates, like other bonds, track US Treasury bonds quite well. Since Treasury obligations are backed by the "full faith and credit" of the United States, they are the benchmark for many other bonds.
Hint: A good way to know what mortgage rates will be tomorrow is to
see what T-Bills did today. You can do this by visiting any site that offers
quotes for commodity traders. T-Bills is a traded commodity. See what they
did today and you will know if mortgage rates will be higher or lower than
they are now.
Here's an oversimplification of the relationships of mortgages to T-Bills:
Short term bonds and long-term mortgages (called Mortgage-Backed Securities, or MBS) compete for the same fixed-income investor dollar. Anything from the Treasury is 100% guaranteed to be repaid, but mortgages are not; therefore mortgages carry more risk of default or early repayment, which could change the return on the investment. Therefore, mortgage rates must be priced higher to compensate for that risk.
Then, there's the volume of loans being made. Unlike many other investment opportunities, no one really knows how many mortgages will be originated, then made available for sale (as bonds) in a given period of time. Recently, a quick drop in interest rates produced a large buildup of loans to be sold to investors as homeowners rushed to refinance. This made way too much bond supply available in too short a time, and investors simply couldn't absorb it all at once. Too much supply, not enough demand; prices had to go down, and yields had to go up to attract investors.
There's also the impact of inflation, which affects both Treasury, mortgage and other fixed-income investments. Rising inflation reduces the actual return on a fixed interest rate investment, so with 2% inflation, that 6% mortgage note returns only 4% "real" interest. So in inflationary times, mortgage interest rates will rise. If inflation is expected to decline, then mortgage interest rates will fall as well, because the future value, to the bond buyer, of a dollar, is not going to decline as much.
Also, a poor economic climate affects mortgages much more profoundly than Treasuries. After all, the US government isn't likely to lose its job and suddenly stop making payments, but it's a safe bet that a percentage of homeowners will, even in good economic times.
There's much more to the structure of the bond, mortgage and capital markets, including government influences and overseas relationships to our capital markets which can also have an effect, but the above should be enough to give you a modest working knowledge of the market. You'll notice that so far, we didn't mention the Fed at all. Fed moves have no direct effect on fixed rate mortgage pricing, but their action or inaction (and expectations thereof) can indeed have indirect effects. Contrary to popular myth, the Fed doesn't have anything to do with mortgage rates. In fact, their most well-known policy tool - the Federal Funds rate - is the overnight interest rate which banks charge each other when a bank needs to borrow money to meet end-of-day reserve requirements.
Those rules say that a bank must have so much cash on hand when the books close at the end of the day, and those funds can be borrowed from another bank at this interest rate.
A good way to keep a handle on the Fed is to remember that the Fed Funds rate is the shortest of short-term rates - literally, an overnight loan - and a fixed-rate mortgage is all the way at the other end of the scale, a loan that lasts as long as 30 years.
The end result is that the Fed raises or lowers interest rates to help address increases or decreases in economic activity. Lower rates can help banks to make certain kinds of loans more cheaply, especially for business and certain kinds of consumer lending, and that can help to generate greater economic growth. Higher rates can cool demand, helping to keep inflationary pressures from forming.
But don't run to call your mortgage broker just because the Fed lowered interest rates yesterday, in the belief that lower mortgage rates must now be forthcoming. Especially in today's high default climate, banks are not going to lower rates anytime soon based on short-term Fed moves. They will keep the additional overnight-borrowing rates profits to offset defaults. It's just business.
As always, consult a competent Certified Mortgage Planner for advice when contemplating a purchase or refinance of a property.