My quick Readers Digest answer when asked this question is: “They are influenced by the 10 year bond”.
But there is a lot more to it that just the 10 year. And I’ll try to keep it short and relatively simple.
Like most other products or services, mortgage interest rates fluctuate based on supply, demand and inflation. But it's not just how many loans borrowers want that matters – interest rates are perhaps most affected by what's happening in the secondary mortgage market.
The secondary mortgage market is where loans are sold by market leaders Fannie Mae and Freddie Mac and bought by investors such as mutual fund companies, banks, hedge funds, and teacher and municipal pension funds.
Short-term loans. One- to five-year adjustable-rate mortgages (ARMs) and other short-term loans generally track the Federal Reserve's Federal Funds interest rate. In some instances, ARMs are tied to the London Interbank Offered Rate (LIBOR), London's Fed Funds equivalent. (In that case, it's called the LIBOR rate, not the Fed Funds rate, and it directly affects interest rates in Europe as well as in the U.S.)
The Fed Funds rate and LIBOR are the interest rates that banks charge each other to lend money overnight, and they influence whether short-term rates go up or down.
When the economy is in a difficult situation, like now, the Govt. keeps the Fed Funds rate very low. This lower rate makes it more affordable for banks to borrow funds. A low Fed Funds rate generally means banks can lend at lower rates because they're spending less to borrow the money.
Recently, the Fed announced it would keep interest rates at below 0.25 percent for a long time in an effort to further stimulate the housing market and, hopefully, the broader economy. The Fed plans to keep interest rates near zero until the unemployment rate drops to 6.5 percent, as long as inflation remains in check.
Long-term loans. Traditional 30-year fixed-rate mortgages tend to track the interest rate of Treasury notes and bonds.
Rates for these long-term U.S. securities fluctuate daily as they're sold at auction to investors. If there is a high demand for the notes and bonds, the interest rates will drop as investors' returns (yields) fall. Since they're paying more for the securities, they're making less money.
The opposite is true when demand for Treasury notes and bonds is low. Investors are paying less to purchase them, which means their yields are higher, and that generally means interest rates follow suit.
The impact of mortgage-backed securities
Since the housing bubble burst, the Fed has gotten more directly involved in the secondary mortgage market in an effort to encourage economic growth. It recently promised to purchase billions of dollars' worth of mortgage-backed securities until the job and housing market improves, hoping to encourage investors to borrow and spend more money.
The move means lower yields – and therefore, lower interest rates – hence lower mortgage rates, because the Fed is taking most mortgage backed securities off the market. If investors want to own and hold mortgage backed securities, they have to compete for them with the Fed….so if there is more competition, the securities rate of interest that buyers are willing to accept is reduced. And rates on the ten year are a fairly good indicator of the direction of mortgage rates.
So, even though home prices seem to be heading back up, it looks like, barring anything unforeseen, that mortgage rates will stay extremely low for a while.
Thanks for reading…Steve Jackson, 561.602.1258
