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.
