What causes mortgage rates to increase or decrease?

So what forces cause mortgage rates to go up or down? These are tied to some fundamental economic activities that take place everyday in our markets, by understanding these you will now be able to better predict and understand what direction rates will probably move.

Europe…the #1 reason mortgage rates are so low!

The #1 reason US mortgage rates are so low right now is because of financial events in Europe. There is a debt contagion spreading throughout the countries of the European Union that is starting to unravel.

Greece, Portugal, Ireland and Spain have already requested bailouts, Italy and Cyprus are probably next in line. So why does the Euro crisis affect rates in the US? Anytime you hear of financial problems coming from Europe, this usually causes a “flight to safety” of investor money into US markets.

A “flight to safety” occurs when overseas investors are nervous about owning European debt and risky assets like stocks, but do not want to miss out on earning a return on their funds, so they allocate money into risk-free U.S Treasury debt to provide a safe-haven AND an investment return. As Treasury yields fall, prices of mortgage bonds move higher which in turn lowers mortgage rates.

Stocks and bonds compete for investment

Stocks and Bonds compete everyday for investors dollars in the open markets, stocks pay a higher rate of return so they are more risky, bonds have a lower return so they are seen as more stable and less risky. Remember: When there is weak economic news (European debt problems, less homes sold etc), this normally causes money to flow out of Stocks and into more stable Bonds, helping Bonds and mortgage rates improve.

But strong economic news (lower unemployment, more homes sold etc) normally has the opposite result, so investors will pull their money from bonds and put it into more risky stocks, thus causing mortgage rates to increase. It is an interesting dynamic that generally bad economic news is good for mortgage rates!

The impact of Inflation

Inflation is eventually going to be a problem sometime in our future because of all the money that is being printed to pay for Government spending. So how will this affect mortgage rates? The bottom line is that as inflation increases, mortgage rates will rise too.

That’s because lenders know that a rise in inflation actually diminishes the value of the money they receive over the life of a loan, as the money they receive for payment simply won’t go as far. So when they see changes in inflation or even anticipate a rise, they increase their interest rates to make up for the loss in future buying power that will happen as a result of inflation.

The Relationship between Mortgage Bonds & Mortgage Rates

The reason that mortgage rates move up or down everyday, is because Mortgage Bonds are traded everyday just like stocks. They either go up or down in price on a daily basis. Here is a current chart of mortgage backed securities:

When mortgage bonds are trading higher (green), mortgage rates move lower, and when mortgage bonds trade lower (red), rates will move higher. As you can see mortgage bonds are currently trading at close to their all time record highs!

When mortgage bonds trade lower, lenders raise their mortgage rates and republish these higher rates to the public. This daily trading of mortgage bonds directly correlates to the mortgage rates we see everyday from lenders. It is not unusual for mortgage rates to sometimes change 2 or 3 times in just one day!

Credit Scores and Mortgage Rates

It is no secret that having good credit scores are important for buyers in this market to score the best rates! For example, did you know a buyer with a 699 credit score purchasing a $400k home with 20% down, will pay an additional fee of 1.5% to get the same rate as a buyer with a 740 score, which amounts to an extra $4800 the buyer has to pay at closing, or they can take a .375% higher interest rate instead that incorporates this 1.5% fee!

To maintain great credit, everyone should get a copy of their credit report once a year so they can make sure they are keeping their scores as high as possible, so when they are ready to obtain financing for anything, they are in a position to score the best rates!  You are entitled to a FREE credit report once a year from www.annualcreditreport.com

A look at mortgage rates over the past 40 years

30-Year FRM, 15-Year FRM, 1-Year ARM Rates, 1992 - 2012

I think it is important that buyers today understand where current rates are in relation to historical averages. For example, this chart below shows the average 30 year fixed mortgage rate over the past 40 years has been 9%, and 6.5% over the past decade! So for any buyers still on the fence looking at buying a home, they are very fortunate that they will be able to qualify for a rate that is at 40 year lows.

Its important today’s buyers understand Cost vs Price!

It is very important that today’s buyers understand that waiting for a reduction in price is not the only way to get a great deal on a home. I still believe there too many buyers today who are fixated on finding the bottom of the market because there is too much emphasis on getting the lowest price. What is just as important is factoring in the overall cost to buy a home and that includes the interest rate and financing costs.

Because as noted above, when rates increase by just 1%, buyers now lose 10% in purchasing power or affordability. Imagine if rates go from 4% to 6%, a buyer now needs a 20% price reduction to afford the same payment as a 4% rate. There is no guarantee that interest rates are going to stay this low for too much longer. Because once they find a solution to Europe(the #1 reason our rates are so low), our mortgage rates will spike. Therefore I believe we are at or very near the bottom of the market when considering the “overall cost to finance a home”.

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