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:
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; and the producers of those goods and services can increase prices. Therefore, a
strong economy 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. |
