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 (i.e. 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, secures 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 credit (loans) increases, so do interest rates. This is
because there are more buyers, so sellers can command a better price, i.e.
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, i.e. 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 (i.e. a slowing economy) is good news for interest rates
(i.e. lower rates).
- Good news (i.e. a growing economy) is bad news for interest rates
(i.e. 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. The higher interest rates will cause increased
accumulation of interest over the next 5 years, such that a lower price (e.g.
$880) will result in the same maturity price, i.e. $1000.
