Where do mortgage rates come from?

Why and how mortgage rates change in the marketplace is often misunderstood – even by the news media. They often report mortgage rates will go down when the Federal Reserve announces a rate cut when sometimes the opposite can happen.

Fed rate changes don't directly affect mortgage rates. Instead, they affect the inflation expectations of investors (see the next section).

The role of the Federal Reserve in our economy is to control inflation so we have long-term economic growth and prosperity. If the economy grows too fast, we get inflation. If the economy shrinks, we have recession.

The Fed's main tool in managing the economy is to change short-term interest rates. They can directly change the rate banks charge each other for loans and the rate the Fed charges banks. Banks eventually change the rates they charge customers for certain loan and savings products as it gets cheaper or more expensive for them to borrow money. Loans indexed to the Prime rate are usually the first to change.

The Fed lowers rates to speed up the economy. Lower rates encourage more business and consumer spending as loans become cheaper and saving becomes less profitable. The Fed raises rates to slow the economy. Higher rates discourage spending as borrowing becomes more expensive and saving money becomes more profitable.

If investors think Fed rate changes will make the economy grow fast enough to cause inflation, the mortgage rates they demand will go up. If they think the Fed's actions will reduce inflation, mortgage rates are likely to fall. There are times when mortgage rates will go the opposite direction of Fed rate changes based on the inflationary impact investors expect.

Did you know that individuals and businesses can invest in securities backed by people's mortgages? Institutions that make mortgages frequently sell them to investors. The mortgage interest homeowners pay provides income to buyers of mortgage-backed securities. That buying and selling of mortgages gives lenders a ready source of money for making mortgage loans. As a result, far more people can get mortgages and buy homes than would otherwise occur.

Investors require a return on their money in exchange for the risk they are taking. That required rate of return directly impacts mortgage rates. Simply put, if the rate offered on a mortgage-backed security is below the return investors require, they won't buy it at face value. To get face value, the institution selling the mortgage must raise their mortgage interest rates to a level that meets the required rate of return.

The rate is generally based on two kinds of risk – inflation expectations and risk the borrower won't repay on time.

Inflation occurs when prices for goods and services rise over time. As prices rise, the purchasing power of a dollar falls. Investors want to ensure that inflation won't erase the value of the earnings on their investments. If they expect inflation to increase, they'll want a higher rate. If they expect inflation to decrease, they'll accept less. As mentioned before, Fed rate changes are a big factor in those expectations.

© 2008. Digital Federal Credit Union