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.
