To understand why mortgage rates change we must first ask the
more general question: why do interest rates change? It is important to realize that there
is not one interest rate, but many interest rates!
- Prime rate: The rate offered to a bank's
best customers.
- Treasury bill rates: Treasury bills are
short-term debt instruments used by the U.S. Government to finance their debt. Commonly
called T-bills they come in denominations of 3 months, 6 months and 1 year. Each treasury
bill has a corresponding interest rate 3-month T-bill rate, 1-year T-bill rate.
- Treasury Notes: Intermediate-term debt
instruments used by the U.S. Government to finance their debt. They come in denominations
of 2 years, 5 years and 10 years.
- Treasury Bonds: Long debt instruments used
by the U.S. Government to finance its debt. Treasury bonds come in 30-year denominations.
- Federal Funds Rate: Rates banks charge each
other for overnight loans.
- Federal Discount Rate: Rate New York Fed
charges to member banks.
- Libor: : London Interbank Offered Rates.
Average London Eurodollar rates.
- 6-month CD rate: The average rate that you
get when you invest in a 6-month CD.
- 11th District Cost of Funds: Rate determined
by averaging a composite of other rates.
- Fannie Mae Backed Security rates: Fannie Mae
pools large quantities of mortgages, creates securities with them, and sells them as
Fannie Mae backed securities. The rates on these securities influence mortgage rates very
strongly.
- Ginnie Mae-Backed Security rates: Ginnie Mae
pools large quantities of mortgages, securitizes them and sells them as Ginnie Mae-backed
securities. The rates on these securities influence mortgage rates on FHA and VA loans.
Interest-rate movements are based on the simple concept of supply
and demand. If the demand for loans increases, so do interest rates. This is because there
are more buyers, so sellers can command a better price, higher rates. If the demand
for credit reduces, then so do interest rates. This is because there are more sellers than
buyers, so buyers can command a lower better price, lower rates. When the economy is
expanding there is a higher demand for credit so rates move higher, whereas when the
economy is slowing the demand for credit decreases and so do interest rates.
This leads to a fundamental concept:
- Bad news a slowing economy is good news for interest rates
= lower rates.
- Good news a growing economy is bad news for interest rates
= higher rates.
A major factor driving interest rates is inflation. Higher
inflation is associated with a growing economy. When the economy grows too strongly the
Federal Reserve increases interest rates to slow the economy down and reduce inflation.
Inflation results from prices of goods and services increasing. When the economy is strong
there is more demand for goods and services, so the producers of those goods and services
can increase prices. A strong economy therefore results in higher real-estate prices,
higher rents on apartments and higher mortgage rates.
Mortgage rates tend to move in the same direction as interest
rates.
However, actual mortgage rates are also based on supply and demand for mortgages.
The supply/demand equation for mortgage rates may be different from the supply/demand
equation for interest rates. This might sometimes result in mortgage rates moving
differently from other rates. For example, one lender may be forced to close additional
mortgages to meet a commitment they have made. This results in them offering lower rates
even though interest rates may have moved up!
There is an inverse relationship between bond prices and bond
rates. This can be confusing. When bond prices move up interest rates move down and vice
versa. This is because bonds tend to have a fixed price at maturity––typically
$1000. If the price of the bond is currently at $900 and there are 10 years left on the
bond, and if interest rates start moving higher, the price of the bond starts dropping.
This is because the higher interest rates will cause increase accumulation of interest
over the next 5 years and so a lower price $880 will result in the same maturity
price $1000.
