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
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
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.
Effect of economic data on rates
Number of arrows indicates potential effect on interest
rates. 1 arrow=least effect, 5 arrows=max. effect