Global events affect stock and bond prices, markets for precious metals, oil and other commodities, exchange rates, employment – and mortgage rates. In fact, many people pay close attention to the economy when they apply for a mortgage, because they want to lock in their loan when rates go down, but not get caught unlocked if rates go up.
My big fat Greek mortgage
For example, consider the many weeks in which it was feared that Greece would default on its debt and pull the whole European Union down with it. Investors wanted their money out of Europe, but where could they safely put it? United States bonds, backed by the full faith and credit of the US government, are still considered the safest investments in the world. Foreign demand for US Treasuries pushed interest rates down, and Americans looking to buy homes or refinance mortgages benefited.
How do Treasury bond prices affect interest rates?
Why, you might ask, would demand for US Treasury bonds push mortgage rates down? It’s because bond prices and bond yields (interest rates) move in opposite directions. For example, say that two years ago, you bought a $1,000 bond and it pays five percent interest ($50) each year (this is called its “coupon rate”). That’s a pretty good rate today, so lots of investors want to buy it from you. You sell your $1,000 bond for $1,200.
What goes down…
The buyer gets the same $50 a year in interest that you were getting. However, because he paid more for the bond, his interest rate is not five percent.
- Your interest rate: $50 annual interest / $1,000 = .05
- Your buyer’s interest rate: $50 annual interest / $1,200 = .042
Your buyer gets an interest rate, or yield, of only 4.2 percent. And that’s why, when demand for bonds increases and bond prices go up, interest rates go down.
…must come up
However, when the economy heats up, inflation becomes a concern. With fewer people wanting to buy bonds, their prices decrease, and then interest rates go up.
Imagine that you have your $1,000 bond, but no one wants it because unemployment has dropped and stock prices are soaring. You end up selling it for $700. The buyer gets the same $50 a year in interest, but the yield looks like this:
- $50 annual interest / $700 = .071. The buyer’s interest rate is now 7.1 percent.
How are mortgage rates related to Treasury bonds?
Mortgage rates track Treasuries pretty well – meaning, they almost always move in the same direction. However, mortgage-backed securities (MBS) are riskier than government-backed bonds. To compensate for this risk, investors require higher interest rates before they will buy mortgages. This spread between Treasuries and MBS fluctuates, but typically runs between one and two percent.
Doesn’t the Fed raise and lower mortgage rates?
You frequently hear that the Federal Reserve is “raising” or “lowering” interest rates. So, if the Fed raises rates by .25 percent, does that mean that lenders jack up mortgage quotes by .25 percent? Not exactly.
The only thing controlled by the Fed is the Federal Funds rate – the rate that banks charge each other for overnight loans to cover their cash needs (every bank is required to keep a certain amount of funds, called reserves, with the Federal Reserve and these funds can be borrowed). However, the rate for these very short-term loans has little to do with rates for long-term loans like mortgages. In fact, when the Fed “lowers” the Federal Funds rate, mortgage rates can increase.
Lowering the Federal Funds rate puts more cash into the economy, but that extra cash is competing for a finite amount of resources – for example, oil. More money competing for the same amount of oil drives prices up. That triggers inflation concerns, which make bonds unpopular, pushing their prices down and interest rates up.