Experience is a great teacher, but not always the most practical one. Take understanding mortgage rates, for example. Interest rate trends sometimes play out over the course of decades. so by the time you have had a chance to personally observe every twist and turn rates are capable of, you might never have a chance to apply that knowledge. Plus, the stakes are too high – a wrong decision about a mortgage might teach you a lesson you'll never forget, but it also might be a lesson you can't afford.
A more practical substitute for learning from experience is to study history. After all, you can absorb other people's experiences much more quickly and cheaply than you can accumulate your own. In the case of mortgages, there is a historical record dating back to the early 1970s, and studying that can show you some of the things rates are capable of much faster than it would take to live through such a full range of experiences.
Historical High, Low, and Average
30-year mortgage rates have spent most of 2015 a little below 4 percent. Is that normal? History suggests not.
Over their full history, 30-year rates have averaged 8.39 percent – more than twice their recent level. In fact, rates just below 4 percent are fairly near the all-time low of 3.35 percent, which was reached in late 2012. At the other end of the spectrum, rates are capable of going considerably higher. The all-time high for 30-year rates was 18.45 percent, reached in October of 1981.
How Quickly Things Change
Record high rates, or even average rates, seem a long way off from today's levels, but things can change quickly. In fact, the relative stability of rates in recent years is somewhat unusual.
Historically, 30-year rates have varied by an average of 0.88 percent year-over-year, either up or down. The biggest 1-year decrease in rates was a 4.56 percent decline for the 12 months ending in February of 1983, something that obviously is not possible today with rates already below 4.56 percent. At the other extreme, the biggest 12-month increase in rates was a 5.83 percent jump for the year ending in April of 1980.
Since rates at current levels are more likely to rise than fall, what this history tells us is that it would not be unusual to find rates 0.88 percent higher a year from now, or up to around 4.8 percent. It wouldn't even be beyond the realm of possibility for rates to be 5.83 percent higher, or up around 9.7 percent.
The Relationship Between 15- and 30-Year Mortgage Rates
Another interesting aspect of mortgage history is the relationship between 15-year and 30-year rates. Longer-term rates are generally higher, but how much higher has varied over time.
On average, 30-year rates have been 0.52 percent higher than 15-year rates. The smallest difference ever was 0.20 percent back in December of 2008, and the biggest difference ever was a full percentage point, reached in November of 2013 and again in March of 2014. Recently, this differential was 0.80 percent, or some 0.28 percent higher than the historical average. This means that for people who can afford the higher monthly payments that come with a shorter mortgage, 15-year rates represent an unusually deep discount these days compared with 30-year rates.
The Fed's Role
You hear Federal Reserve monetary policy mentioned a great deal in connection with interest rates, but the Fed does not set rates for mortgages. Those rates are determined by an open market, based on a combination of factors including competition, default rates, and inflation.
In the aftermath of the Great Recession, the Fed took the unusual step of buying up huge amounts of long-term bonds and mortgage-backed securities in an effort to support the struggling housing market by driving mortgage rates down. This policy was called "quantitative easing," and was a temporary measure that has since been discontinued. Significantly, mortgage rates did not climb back to previous levels when the Fed discontinued its quantitative easing measures, underscoring the limited influence that Fed policy has on mortgage interest rates.
The Inflation Factor
What is likely a bigger factor in the unusually low level of today's mortgage interest rates is the near disappearance of inflation. For lending to be worthwhile, lenders have to make sure the interest rates they charge exceed the inflation rate. Thus, interest rates tend to rise and fall according to the level of inflation.
Since the early 1970s, the annual inflation rate has averaged 4.17 percent, and 30-year mortgages have been an average of 4.22 percent higher at 8.39 percent. As of August of 2015 though, both the inflation rate and the differential between mortgages and inflation were unusually low. Over the prior 12 months, inflation was just 0.20 percent, and 30-year rates were 3.71 percent higher at 3.91 percent. This suggests that if either inflation or the cushion between mortgage and inflation rates returns to more normal levels, mortgages would move higher – and perhaps considerably higher. This makes inflation a key thing to keep an eye on if you want to monitor the direction of mortgage interest rates.
The thing about history is that it can show you what mortgage rates are capable of, but it cannot reliably predict what will happen in the future. Still, while history is not a perfect road map, it does put the current rate environment into perspective. That perspective is a reminder that today's rates are unusually low, and they are capable of going much higher in a hurry if inflation starts to flare up.