Making Sense Of Mortgage Rates

The Federal Reserve has cut interest rates a lot in the last few months, so mortgage rates should drop, too...right?

Not so fast. After the latest round of cuts in Jan 08, mortgage rates actually shot up 50 basis points. (A basis point is 1/100th of a percent…so that's ½ %...the largest one-day increase in the last 10 years.) All of this seems a little counter-intuitive and can get pretty complex. Fortunately, we can break out our crystal ball and gain a little more understanding of mortgage rates without going cross-eyed. And not to worry, we'll avoid doing too much math in public while we're at it.

Fed Governs Short-Term Rates

When the Federal Reserve trims rates, it does affect you...just not necessarily in the mortgage department. The Fed's domain is short term rates. These are the rates that banks use for short term credit, such as business loans and home equity lines. So if you're paying on a Home Equity Line of Credit (HELOC), then congratulations! You've probably already noticed that your payment has dropped.

10 Year Treasury Note Measures Long-Term Rates

Mortgages, however, are governed by other influences, the same ones that affect long-term investments. The institutions that lend you money for a home are investors…people just like you and me…ok…with a LOT more money…but when they invest, they want to get the best return for their money, just like we do when shopping for a good savings account or mutual fund. Since most mortgages last 10-12 years, these investors compare their options to other notes with the same term, or length…namely the 10 Year US Treasury Note.

The Treasury note basically guarantees a rate of return, or interest rate, for 10 years. And since it's the government giving the guarantee, we know they're good for it, so it's a low-risk investment. Mortgages, however, are a little riskier.. People could stop paying them. Investors expect to get paid a higher return for taking on more risk. This means that the rate of return, or interest rates, will have to be a little higher than the interest rate for the 10 Year Treasury Note. That difference has been 1.7-2.0 percentage points, give or take, for the last 10 years. So, mortgage rates are directly tied more to the 10 Year Treasury Note than what the Federal Reserve does.

Inflation Concerns Raise Mortgage Rates

So the question then becomes…what influences long-term rates? The simple answer here is inflation. The long-winded answer is much more complicated, but we'll get the gist of Mortgage Rate changes by taking a closer look at inflation.

What is inflation? It's how much the cost of goods rise or how much prices rise to be able to buy the same loaf of bread. If prices rise, then you can buy less with the same amount of money. In fact, you'd have to have more money to buy the same amount of goods. Lost yet? If so, look here: http://inflationdata.com/Inflation/Articles/Definitions.asp If not, keep reading.

Let's say you've got a Savings account with $100 that gets 2% interest. After a year, you'd have $102. Not bad.

Now let's say the inflation rate is 2%. In a year it would take $102 to buy the same amount of goods that $100 does right now. So if your savings account is 2% and inflation is 2%, then your money increases just enough to keep pace with inflation and your buying power remains just the same as it was a year ago. In other words, even though you got 2% on your money, you're not any richer than you were a year ago. (As a side note…if you kept that same $100 stuffed inside your mattress, you'd actually be poorer now than you were last year…yikes!)

An investor's goal, of course, is to make more money, but we now know that a better way to say it would be increasing their buying power. When they think that inflation is going to rise, they build that outlook into their expected rate of return and will only buy investments with higher interest rates that compensate for higher inflation.

Tying It All Together

Mortgages are long-term investments that are governed by factors like inflation. Recently, the price of energy and goods is on the rise (oil topped $100 per barrel for the first time ever) and the Fed raised their estimate for inflation. To top it off, the Federal Reserve is cutting short term rates to increase spending (putting more money into the economy lowers your buying power), raising inflation expectations even more. Mortgage Investors track these indicators and have raised rates accordingly.

Hopefully this sheds a little light on the wily and seemingly unknowable changes in mortgage rates.