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.
