Factors that Affect Mortgage Rates: The Economy
When it comes time to buy a new house, you know that you need to get your credit in shape to get the lowest possible rate. You know that paying off debt and coming up with a big down payment. can lead to a better rate. However, these aren’t the only factors influencing your mortgage interest rate. This article explains how the state of the economy influences mortgage interest rates.
4 factors that drive mortgage interest rates
Health of the labor market
When the labor market (employment and wages) is growing, interest rates on home mortgages tend to go upward, too. In part, mortgage interest rates rise because demand for mortgages tends to be stronger when the labor market is strong. Additionally, a strong employment raises expectations of inflation in the future. To compensate for higher expected inflation, lenders tend to raise interest rates on mortgages during times of strong economic growth.
Over the past two years, employment and wage growth have been strong in the United States. A strong labor market leads to higher inflation expectations, which push up the nominal part of interest rates, Tendayi Kapfidze, chief economist for LendingTree said.
Of course, the health of the labor market is just one factor that influences mortgage rates. You may see interest rates tick upward during strong economic growth. However, you don’t need to panic about rising interest rates if you buy a house during a strong economic growth.
Over time, prices tend to rise. A dollar today doesn’t buy nearly as much as it did a few decades ago, because prices on almost all items have increased since then. In fact, by one measure of inflation, you would need $1.92 today to buy as much as you could with one dollar in 1990.
Inflation doesn’t just influence our own purchasing power. Lenders have to consider the effects of inflation when setting mortgage interest rates. Lenders need to set interest rates high enough that they will maintain a profit over the long haul. Kapfidze explained, “When lenders start to expect inflation rates to increase, they’ll start to raise interest rates across the board. If they don’t, they won’t expect to earn a profit.”
Between 1972-1983, the U.S. experienced unusually high inflation. Inflation rates hit double digits several times during those years. With inflation running so high, it’s no surprise that mortgage rates rose to 18.53% by October 1981. Once inflation and inflation expectations fell, rates on mortgages fell, too.
Federal Reserve activity
The Federal Reserve is the central bank of the United States. Its goal is to maintain low inflation while fostering economic conditions that promote full employment.
The Federal Reserve works toward its objectives using monetary policy tools. One of its most important tools is open market operations. Open market operations allow the Fed to buy and sell securities. In particular, the Fed buys or sells Treasury bills and mortgage-backed securities (MBS) to influence mortgage rates.
“The Federal Reserve influences mortgage rates indirectly by buying or selling Treasury bills. It influences rates directly by affecting the spread between Treasury yields and mortgage-backed securities,” Kapfidze explained.
Buying more securities tends to send mortgage interest rates down. When the Federal Reserve sells securities, mortgage interest rates tend to move up.
The bond market
For the average person, a mortgage is just a loan, but for institutional investors, mortgages are an investment. Many mortgage lenders don’t keep mortgages on their balance sheet. Instead, lenders bundle mortgages together and sell the bundles as Mortgage-Backed Securities (MBS).
MBS is a type of bond investment. Investors could opt to buy U.S. Treasury bills, corporate bonds or other bond investments including MBS. Since U.S. Treasury bills are considered the safest investment, mortgage interest rates need to be higher than the rates on U.S. Treasury bills. Over time, as rates on long-term U.S. Treasury bills rise and fall, mortgage interest rates rise and fall with it.
How the Federal Reserve influences mortgage rates
Lenders that extend mortgages set interest rates on their own. They don’t ask the Federal Reserve how to set rates. If the Fed has no practical power to set mortgage rates, how does its action influence mortgage rates?
One common misconception about mortgage interest rates is that the federal funds rate (an interest rate set by the Federal Reserve) influences mortgage interest rates.
“The Fed Funds rate has close to zero influence on mortgage rates,” Kapfidze said. “During the last housing boom between 2001-2008, the funds rate was increasing, but mortgage rates were falling.”
That’s not to say the Federal Reserve is unimportant in determining mortgage interest rates. The Fed influences mortgage interest rates by what it holds on its balance sheet. Right now, the Federal Reserve has $4.3 trillion in assets. Just over half its assets are U.S. Treasury securities. Another 40% are MBSs.
By buying and selling these assets, the Federal Reserve influences how mortgage lenders set interest rates. Following the financial crisis in 2008, the Federal Reserve used permanent open market operations to drive long-term interest rates (including mortgage rates) downward. During this time, the Federal Reserve bought trillions of dollars of Treasury securities and MBSs which drove interest rates on mortgages down from 6.24% at the start of 2008 to below 4% by the end 2011. Today, the Federal Reserve is selling off assets or allowing the assets to mature. As a result, interest rates are slowly starting to rise.
Treasury yields and mortgage interest rates
Treasury bills (also called T-bills) are loans to the U.S. government. Investors consider the loans the lowest risk asset in their portfolios. The U.S. government issues T-bills, so they pose a low risk of default.
Because T-bills are such a low risk investment, the yields on T-bill’s is often called the “risk-free” rate. That means it’s the rate of return you can expect to earn if you don’t take on any risk.
Mortgage lenders often consider the yield on 10-year T-bills when setting interest rates on their own loans. The rates on mortgages have to be somewhat higher than rates on T-bills to compensate lenders for the risk they are taking. The difference between yields on 10-year T-bills and current 30-year fixed rate mortgages is sometimes called a spread.
Most of the time, the average spread is under 2%, but during times of uncertainty, spreads rise. For example, in December 2008 in the midst of the financial crisis, the spread was nearly 3%.
Although the spread between mortgage interest rates and T-bills varies over time, the T-bill rate is still an important factor in determining average mortgage interest rates. As rates on 10-year T-bills rise and fall, you can expect mortgage interest rates to rise and fall with it.
It’s important to note that not all T-bills yields are equally correlated with mortgage interest rates. For example, the yield on a 1-year T-bill tracks closely with the federal funds rate, but has very little correlation with mortgage interest rates. Mortgage interest rates tend to track closely with Treasury bills with long maturities (like the 10-year Treasury).
Should I lock in my mortgage rate when rates are rising?
Despite the fact that interest rates have been rising for the last year and a half, mortgage interest rates are still close to all time lows. For many people with adjustable-rate mortgages, that means that now is the time to refinance their mortgage to a fixed rate.
Of course, with so many factors influencing mortgage interest rates, it’s impossible to know where rates will even be one year from today. Mortgage interest rates could be higher, or they could be lower.
Locking in an interest rate always means that you’re giving up the possibility of a lower rate in the future. But for many people, an affordable and predictable monthly mortgage payment is more important than the possibility of an even lower payment in the future. When predictability matters a lot, it makes sense to lock in a fixed-rate mortgage whether mortgage interest rates are rising or falling.
What can consumers do about mortgage interest rates?
Factors outside of your control tend drive mortgage interest rates, but that doesn’t mean you’re powerless to get a great rate. You can dispute errors on your credit report, pay down credit card debt (to reduce your debt-to-income ratio) and shop around for the best rate. Saving just a fraction of a percentage on your mortgage can save you thousands of dollars over the life of a mortgage. You can’t control the Federal Reserve or the economy, but you can take steps to get the best possible mortgage rate. That’s something you should do no matter the state of the economy.