It's All Related: Interest, Mortgages, the Economy

One of the prime considerations when a person is looking to refinance or buy a house is the prevailing mortgage rate in the housing market because the rate has a direct economic impact on the borrower’s disposable income and liability. 

But what affects mortgage rates? The economy, interest rates, and mortgage rates are interwoven, with the US Federal Reserve (Fed) having a direct (and derivative) effect on each of these. 

The Economy and Interest Rates

The Fed’s policies are based on the economic situation in the US. The Federal Open Market Committee (FOMC), which can be called Fed’s decision-making arm, assesses the US’ economic health, based on quality data by various agencies. Based on what the FOMC believes about the economic condition (like growth, inflation, employment), the Fed decides its rates. The federal funds rate is one of the key policy rates, and the other crucial monetary interest rates, like the discount rate and the prime rate, are influenced by the federal funds rate set by the Federal Reserve.

When the Federal Reserve keeps the federal funds rate at low levels, it affects the entire US economy through other interest rates that make borrowing for people and businesses cheaper. It encourages people to take consumer loans to spend and businesses are induced to borrow for expansion and other purposes—all of which helps to stimulate economic growth and increase employment.

There are situations such as very high inflation when the central bank increases the interest rates in order to control the money supply in the economy. The target for the federal funds rate was as high as 20% in the inflationary early 1980s; the rate has declined steadily until recently. The FOMC raised the target range for the federal funds rate to 0.25% - 0.5% from December 2015 onward. (Related reading, see: The Fed's New Tools For Manipulating The Economy.)

The change in the federal funds rate is transmitted through the open market operations (OMOs) (i.e., buying or selling of US Treasury bonds). If the Fed aims to increase the money supply in the economy, then it buys bonds, giving out cash in exchange. When the Fed buys bonds, bond prices move up and the resultant increase in the money supply makes borrowing cheaper, bringing the interest rates down.

Conversely, if the Fed aims to squeeze the excess money supply, then it sells bonds and receives cash. Selling bonds decreases bond prices while simultaneously decreasing the money supply, which means less money circulating in the economy.  That makes borrowing more expensive and pushes interest rates upward. As a rule of thumb, bond prices and interest rates move in opposite directions. (For more, see: Why Do Interest Rates Tend To Have An Inverse Relationship With Bond Prices?)

The Links With Mortgage Rates

Mortgage rates are not immediately affected by a change in the economic situation or interest rates, but there are many links that slowly transmit their influence. So, what do the mortgage rates depend on?

Long-term Treasury yields directly impact fixed mortgage rates (long-term yield means a 10-year and 30-year).  There is another product that competes for the same investors who invest in 10-year or 30-year Treasuries, known as mortgage-backed securities (MBS). Thus, as soon as yields rise, these products also need to offer higher returns to attract investors, which is possible only when the loans are given out at a higher rate. Thus, higher yields result in increased mortgage rates. (Related reading, see: Profit From Mortgage Debt With MBS.)

Now let’s relate the yields on Treasuries to the economy. Say that the economic outlook is bleak; people like to move out of stocks towards government bonds and securities for investment, as they are considered the safest. This increases the demand for these instruments, pushing bond prices up. As bond prices move up, the yield (or return) on them falls. As yields fall, mortgage rates also start coming down. Thus, on the whole, a sluggish economic scenario will be accompanied by lower mortgage rates (via bond market) and lower policy rates as the central bank tries to invigorate the economy. The opposite is true when the economic situation and outlook is good.

While the federal funds rate (and other interest rates) does not have a direct effect on long-term fixed mortgage rates, they do have a direct effect on the adjustable-rate mortgages (ARM). This is because the adjustable-rate loans are reviewed and revised on a monthly, semi-annual, or annual basis, depending on the tenure and are linked to one-year Treasury yields.

The yield curve is a curve showing the short-term and long-term Treasury yields. The table below shows the daily Treasury yield curves for different durations from 2007-2015 (first day of the year), along with the mortgage rate around that time. In a normal economic scenario, the long-term yields should be higher than short-term yields. Remember, that there is always a spread between the long-term rates and mortgage rates to account for the risks associated with a mortgage.

Date

3 Months

1 Year

10 Years

30 Years

Mortgage Rates

01/02/2007

5.07

5.00

4.68

4.79

6.22

01/02/2008

3.26

3.17

3.91

4.35

5.76

01/02/2009

0.08

0.04

2.46

2.83

5.05

01/04/2010

0.08

0.45

3.85

4.65

5.03

01/03/2011

0.15

0.29

3.36

4.39

4.76

01/03/2012

0.02

0.12

1.97

2.98

3.92

01/02/2013

0.08

0.15

1.86

3.04

3.41

01/02/2014

0.07

0.13

3.00

3.92

4.43

01/02/2015

0.02

0.25

2.12

2.69

3.63*

Source: US Department of the Treasury, Freddie Mac (the mortgage rate is for the whole month and not the particular date) *based on primary mortgage market survey (as on January 22, 2015). Figures in percentage.

The Bottom Line

When contemplating taking out a home loan, you should check which direction the fixed mortgage rates are heading and look out for the Federal Reserve’s statement on the economic situation, along with the pattern of the yield curve. These sources can give valuable guidance on the economic situation and mortgage rates. (For more, see: How Interest Rates Affect The Housing Market.)