Mortgage interest rates have a very significant impact on the overall long-term cost of purchasing a home through financing. On the one hand, mortgage borrowers are seeking the lowest possible rates; on the other, mortgage lenders have to manage their risk through the interest rates they charge. The lowest mortgage interest rates are only available to borrowers with the most solid finances and stellar credit histories.
While the financial health of borrowers affects how good an interest rate they can get, larger economic factors and government financial policy affect the whole mortgage rate universe. You can boil it down to these five important factors. All represent basic rules of supply and demand in one form or another. It's a little technical, but learning these principles will give you a good way to think about what you're paying now and what could be coming in the future.
The gradual upward movement of prices due to inflation is an essential factor in the overall economy and a critical factor for mortgage lenders. Inflation erodes the purchasing power of dollars over time. Mortgage lenders generally have to maintain interest rates at a level that is at least sufficient to overcome the erosion of purchasing power through inflation to ensure that their interest returns represent a real net profit.
For example, if mortgage rates are at 5% but the level of annual inflation is at 2%, the real return on a loan in terms of the purchasing power of the dollars the lender gets back is only 3%. Therefore, mortgage lenders carefully monitor the rate of inflation and adjust rates accordingly.
The Level of Economic Growth
Economic growth indicators, such as gross domestic product (GDP) and the employment rate, also influence mortgage rates. Higher economic growth levels generally produce higher incomes and higher levels of consumer spending, including more consumers seeking mortgage loans for home purchases. That's all good, but the upswing in overall demand for mortgages tends to propel mortgage rates higher. The reason: Lenders only have so much money available to lend out.
Naturally, the opposite effect results from a weakening economy. Employment and wages decline, leading to decreased demand for home loans, which in turn puts downward pressure on the interest rates offered by mortgage lenders.
Federal Reserve Monetary Policy
The monetary policy pursued by the Federal Reserve Bank is one of the most important factors influencing both the economy generally and interest rates specifically, including mortgage rates. The Federal Reserve does not set the specific interest rates in the mortgage market. However, its actions in establishing the Fed Funds rate and adjusting the money supply upward or downward have a significant impact on the interest rates available to the borrowing public. Generally, increases in the money supply put downward pressure on rates, while tightening the money supply pressures rates upward.
The Bond Market
Banks and investment firms market mortgage-backed securities (MBSs) as investment products. The yields available from these debt securities must be sufficiently high to attract buyers. Part of this equation is the fact that government and corporate bonds offer competing long-term fixed-income investments. The money you can earn on these competing investment products affects the yields the MBSs offer. The overall condition of the larger bond market indirectly affects how much lenders charge for mortgages. Lenders have to generate sufficient yields for MBSs to make them competitive in the total debt security market.
One frequently used the government-bond benchmark to which mortgage lenders often peg their interest rates is the 10-Year Treasury bond yield. Typically, the average spread for MBSs above the 10-year Treasury bond yield is approximately 1.7%. MBS sellers must offer higher yields because repayment is not 100% guaranteed, as it is with government bonds.
Housing Market Conditions
Trends and conditions in the housing market also affect mortgage rates. When fewer homes are being built or offered for resale, the decline in home purchasing leads to a decline in the demand for mortgages and pressures interest rates downward. A recent trend that has also applied downward pressure to rates is an increasing number of consumers opting to rent rather than buy a home. Such changes in the availability of homes and consumer demand affect the levels at which mortgage lenders set loan rates.
The Bottom Line
Mortgage rates are tied to the basic rules of supply and demand. Factors such as inflation, economic growth, the Fed’s monetary policy, and the state of the bond and housing markets all come into play. Of course, your financial health will also affect the interest rate you receive. So do your best to keep it as healthy as possible. For more, see How Interest Rates Work on a Mortgage.
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