Why Do Mortgage Rates Change?
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.
