Many consumers eagerly follow mortgage rates trying to time a refinance or in anticipation of buying a new home. Most don’t really understand the dynamics of what causes mortgage rates to change. What follows is an explanation of how this occurs. Please note, many of the concepts have been simplified to make them easier to understand & follow.
How Often Can Mortgage Rates Change?
First it’s important to understand that mortgage rates can change just like stocks, by the minute! Normal practice though, is lenders set their rates daily. They take a peek at the financial markets when they open to get a feel for how the day may go, and usually publish their rates between 10am and 12am. Lenders do reserve the right to change rates at any time without notice, if market conditions change dramatically enough later in the day. Of course, lenders are more likely to raise rates rather than lower them.
What Affects Mortgage Rates?
In one word, INFLATION! More accurately, it’s the financial markets’ anticipation of inflation that causes mortgage rates to change. So now you need to understand inflation.
Why Does Inflation affect Mortgage Rates?
Inflation is the nemesis of long-term investors. Over time it causes prices to rise & buying power to decline. For example, let's say you won a lottery that paid you $1,000 every month for 30 years. At first, that $1,000 would buy a lot of things, but over time as prices went up, you’d be able to buy less & less with that same $1,000.
In the same way, inflation eats away at the value of a long-term fixed instrument like a bond or a mortgage. Because bond investors are very aware of this, they’ll require a higher rate of return, through a higher interest rate, on their investment to compensate them if they feel inflation will be increasing.
So, How Do Mortgage Rates Change?
Many people mistakenly think mortgage rates change with the 10-year bond. Actually, mortgage rates change based on the trading of Mortgage Backed Securities (MBS) on Wall Street. The 10-year bond can be used as a leading indicator of what MBS & mortgage rates are doing, but it’s important to understand that this is not really accurate.
What’s a Mortgage Backed Security?
When a lender gives someone a mortgage, they may or may not be actually lending their own money. They may be actually lending money off a credit line. In either case, at some point they will usually seek to recoup their money so they can lend it to the next customer. To recoup their money they go to Wall Street and sell the rights to the loan, but retain the servicing of the loan. This transaction is accomplished through the creation of a Mortgage Backed Security (MBS). So when you make a payment on a mortgage, the lender receiving your payment keeps part of the interest as their fee for servicing the loan, and then forwards the rest of your payment to Wall Street and whoever owns the MBS. Just like stocks & bonds, MBS are traded on Wall Street. The changing sales prices of the MBS, lead to changes in mortgage interest rates.
Does Anything Else Affect Mortgage Rates?
The stock market also has an effect on mortgage interest rates. It’s important to understand that there’s a limited amount of liquid assets or money in the financial markets. These assets can be in the form of checking & savings accounts, mutual funds, individual stock portfolios, and retirement funds like IRA’s & 401(k)’s. They can be invested in two basic parts of the financial market – equities (stocks) or fixed instruments (bonds and securities). When investors put assets into stocks and drive the stock prices up, they often pull those assets out of the bonds & securities. This drives the prices of bonds & securities down (basic supply & demand) forcing the yields or interest rates up. Conversely, when there’s a sell-off in the stock market, those assets are often put into bonds & securities for safety, resulting in rates dropping.
World events also affect the financial markets. War, political turmoil or a foreign country’s economic problems can make international investors nervous enough to put their assets into the U.S. bond & securities markets as these markets are perceived to be the safest havens in the world. This “flight to quality” can cause interest rates to drop in spite of inflationary concerns.
The Federal Reserve & Mortgage Rates
Many consumers incorrectly believe the Federal Reserve directly controls mortgage rates. The Fed actually only controls the Fed Fund & Fed Discount Rates, which are very short-term loans when compared to a 30-year mortgage. The Fed Discount Rate is the interest rate that banks can borrower money directly from the Federal Reserve at the “discount window”. The Fed Fund Rate is the interest rate at which private depository institutions (mostly banks) lend balances (federal funds) at the Federal Reserve to other depository institutions, usually overnight. This rate affects the Prime Rate that banks set. Most Home Equity Lines Of Credit (HELOC) and credit card rates are tied to Prime. The Fed uses the Fed Fund Rate to try and control the U.S. economy, lowering the rate to stimulate the economy and raising it to slow inflation. It’s what the bond & securities markets anticipate the Fed’s actions will have on inflation that dictates what mortgage rates will do! Often when the Fed lowers its rate to stimulate the economy, the financial markets will anticipate inflation increasing and will react by raising interest rates. Conversely, mortgage rates often drop when the Fed increases the Fed Rate because the markets anticipate the Feds actions slowing inflation.
It’s important to note that sometimes the financial markets can be disappointed in the Feds actions and will react in unanticipated ways. Also, the fact that we are moving closer to a global economy means it’s also important how foreign markets react to the Feds movements.
Summary
Hopefully, this sheds some light on the complicated dynamics affecting mortgage rates. The average person can no more predict what mortgage rates will do on any given day, than they can predict what the stock market will do. The key is finding a Certified Mortgage & Equity Planner who can assist you in analyzing the volatility of current market conditions when you’re ready for a new mortgage, so you can make a better informed decision.
Drew Sygit, CMPS, CALO, MBA
www.TheLendingEdge.com
