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!
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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 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 very strongly.
Ginnie
Mae-Backed Security Rates
Ginnie Mae pools large quantities of mortgages, securitizes
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 loans increases,
so do interest rates. This is because there are more
buyers, so sellers can command a better price, 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,
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 a Slowing
Economy is good news for Interest Rates = Lower
Rates.
Good News a Growing
Economy is bad news for Interest Rates = 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 rates.
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. This is because the higher
interest rates will cause increase accumulation of
interest over the next 5 years and so a lower price
$880 will result in the same maturity price $1000.
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