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.
