What controls mortgage rates?

No single individual or entity controls mortgage rates, so the more appropriate question would be to ask “What factors control mortgage rates?”

Before discussing the specific factors in detail that DO control mortgage rates, let us first discuss which ones DO NOT control mortgage rates.  The most common misconception among consumers is that the Federal Reserve (The Fed) directly controls mortgage rates.   This is absolutely not true.   Unfortunately, the media and also some unscrupulous mortgage advertisements help to spread this misinformation to consumers, which only adds to the confusion.  The Federal Reserve only has the power to control two key short term interest rates, known as the Federal Funds Rate and the Discount Rate.  

Here’s a chart showing mortgage rates compared with the Fed rate over the last 10 years.

There is a broad pattern that exists between the two, but there is no direct correlation between the Fed rate and mortgage rates. Notice some specific examples:

* The spread (difference) between the Fed rate and the 30 year mortgage rate was half a point around the beginning of 2001. The Fed lowered rates from 6.5% to 1.75% over the next 12 months, but mortgage rates remained the same.
* From mid 2003 until mid 2004, the Fed held rates steady at 1%, but mortgage rates actually spiked by 1%, fell 1% and then rose again by almost 1% during this same period.
* From mid 2004 until mid 2006, the Fed raised rates from 1% to 5.25%, but mortgage rates were relatively unchanged during this same period.
* More recently, the Fed has lowered rates while mortgage rates have resumed an upward trend.

To understand the economic forces that determine mortgage rates, you have to first understand what happens to a mortgage after closing.  Almost all mortgages originated in the U.S. are pooled into groups and sold as bond-like financial instruments (mortgage backed securities) on Wall Street, also known as the “secondary market”.  Since these mortgage backed securities function much the same as bonds and have similar characteristics as bonds, their price is also influenced by many of the same factors that affect bond prices.

Now let’s look at the big picture in perspective.  There are two major vehicles of investment – Stocks and Bonds.  If you read my article on mortgage backed securities, then you already know that as an investment, they somewhat resemble bonds.   Stocks and bonds tend to have an inverse relationship, meaning when one goes up, the other often goes down.  Why?  Investors tend to buy stocks when the economy is doing well, since the potential for proit is greater.  Likewise, they tend to buy bonds when the economy is in a state of weakness.  Although there are exceptions to this rule, this is typically the pattern.  Picture a see-saw of money constantly shifting between the two based on the state of the economy (and investors’ PERCEPTION of the state of the economy).  We all know that when stocks are sold, their share price goes down.  But what about bonds?  The same holds true for bonds.  When investors buy bonds, their price goes up, and when they sell, the price goes down. 

MORTGAGE RATES are a direct result of the YIELD of mortgage backed securities. When the PRICE of morgage backed securities RISE, the YIELD FALLS, which LOWERS MORTGAGE RATES.  When the PRICE of mortgage backed securities FALL, the YIELD RISES, which RAISES MORTGAGE RATES. 

So now you understand the basic fundamentals.  Understanding the reasons why the prices rise and fall is a little more complex.  Let’s take our above conclusions and review some basic moves in the economy that can have an effect on the price of mortgage-backed securities:

* Investors sell stocks and put their money into bonds, including mortgage backed securities.  This typically causes mortgage rates to FALL since the demand raises the price, which in turn lowers the yield.  Ironically, a lowering of the Fed rate often triggers a rush to buy stocks, which causes a bond selloff causing mortgage rates to RISE.  So the next time you hear the Fed is about to lower rates, don’t assume that mortgage rates will follow suit!

* Prices of competing bonds, such as T-Bonds, T-Bills, and corporate and municipal bonds.  All bonds are competing for the same investors, so their respective yields tend to influence one another.

* Economic indicators such as inflation, unemployment, GDP and even the National Debt.

* Investors’ perception of the overall housing market.

* Investor confidence in the ability of mortgage entities such as Fannie Mae, Freddie Mac and FHA to accurately determine risk.  Lax underwriting standards of the subprime era have added to investors’ skepticism of the risk management ability of these entities.

As our economy continues to change, the factors that affect mortgage rates may change as well.

Always obtain the advice of a competent mortgage professional before locking a rate.  Don’t assume that simple actions such as a Fed rate cut will automatically mean that mortgage rates will drop in tandem.  The economy is much more complex than the media portrays on the evening news. 

CONTACT JOHN JONES at (972) 978-3553.  Licensed loan officer in the state of Texas (TX12304)