What Impacts Mortgage Rates?

There are many reasons why mortgage interest rates change. While the Federal Reserve’s role in monetary policy is a factor, it is just one of the pieces connected to interest rates. Other external elements include inflation and the economy, the bond market, and the housing market. Personal factors, including credit score, loan-to-value, debt-to-income, loan amount, closing costs, discount points, and property type are also associated with the rate you receive when applying for a mortgage, but this blog post will just explore external factors.

Inflation and the Economy

Inflation is the rise in prices for goods and services and leads to decreasing purchasing power for consumers. Mortgage lenders watch inflation closely to ensure they are not losing money over time on loans. For example, if a mortgage rate is four percent but inflation is three percent annually, the purchasing power held by the lender would be minimal. Lenders must account for the risks and costs associated with lending, and that gap often tightens as inflation increases.

Gross domestic product (GDP) and the employment rate are two economic growth indicators that influence mortgage rates. As the economy grows, wages and consumer spending often increase, leading to an increase in demand for mortgage loans. Rates tend to go up when mortgage demand increases and go down when demand decreases. One reason is because lenders only have so much capital to lend. Another reason is because of investor activity. Mortgage rates are closely tied to the 10-year Treasury bond yield, with one rate typically following the trajectory of the other rate. This dynamic will be explained later in the blog post.

Monetary Policy

The Federal Reserve (Fed) oversees the U.S. financial system to help ensure it remains safe and sound, balancing the responsibility of achieving maximum employment and keeping inflation at a manageable level. The Fed does not set mortgage rates, but its decisions can influence them. For example, when the Fed raises short-term interest rates, it becomes more expensive for lenders to borrow money and can lead to higher mortgage rates. In contrast, when short-term interest rates go down, it is less expensive for lenders to borrow money, and mortgage rates may decrease. Short-term interest rates generally increase when the Fed tightens the money supply and decrease when it adds to the money supply.

Bond Market

The rates offered on 10-year Treasury bonds (T-bonds) are closely tied to mortgage rates because they are competing long-term fixed-income investment options, and often even bundled together for investors. Mortgages can be packaged to investors as mortgage-backed securities (MBSs), but they typically have to offer a higher yield than Treasury bonds because repayment is not 100 percent guaranteed like it is with T-bonds. It may seem odd that 10-year Treasury bonds and mortgage-backed securities are so closely linked, especially given that a great percentage of mortgages are 30-year loans, but it is common for mortgages to pay out over a 10-year period when the owner decides to refinance, move, or pay off the mortgage early.

The bond market must compete with other investment options. Bond rates often increase when the economy is strong and job growth is high because other investment options can be more appealing during those times. However, when there is an economic downturn and the unemployment rate increases, bonds are generally viewed more favorably because of the stable returns they offer. The bond market does not have to offer rates that are quite as high when this occurs, and as a result, mortgage rates typically decline as well.

Housing Market

Mortgage rates are also impacted by the housing market. When demand decreases, rates often go down. In contrast, rates typically increase when demand increases. The reasoning behind shifts in demand are not always the same. For example, demand may be low in one area because a large percentage of people may choose to rent rather than buy. Demand may be low in other areas due to a limited number of homes on the market.

If you are attempting to determine the best time to apply for a mortgage, try not to focus too much on one factor. Instead, stay informed on how inflation, the economy, monetary policy, the bond market, and the housing market all impact mortgage rates in their own ways.

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