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, 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.
