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.
