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.
