Don’t blame the broker if you don’t like your mortgage rates. It’s not his fault. In fact, even the highest officials in the lender’s organization aren’t to blame. Confusion regarding the fluctuation of mortgage rates is common, especially when we hear about the Fed, “voting to keep mortgage rates low.” What the Fed is really doing is voting on measures that may influence the rates. Mortgage rates are set by a complex set of economic factors including the state of the housing market, secondary markets, investor demand, federal intervention and other factors.
The Housing Market
Supply and demand is a principle as old as time that is still relevant today. In fact, it’s one of the primary influencing factors in mortgage rates. In real estate, agents look at supply and demand in a time scale, called “available inventory." They look at how long it would take to sell total volume of houses on the market, so inventory is measured by weeks or months. The longer the inventory, the lower prices become.
Supply is reduced every year by demolitions, abandonments, conversions, and disasters like earthquakes or floods. It can also be reduced by government regulations that limit growth in certain geographic areas. To meet supply, new homes are built, adding to the supply and maintaining balance. Currently, the balance is far off the mark. When supply outpaces demand, prices and mortgage rates drop as a natural consequence.
Demand is strongly affected by populations in any given area. As certain job markets grow, demand for housing in those geographic areas goes up. The ability of potential homeowners to borrow money also affects demand. This is the case in today’s economic climate. Demand is suppressed by the inability of many buyers to borrow money. But just a few years ago, demand was high and supply was low. At that time, mortgage rates rose in response to high demand for loans.
The Secondary Market
Mortgage rates are also strongly affected by the secondary market. When the consumer takes a loan with a mortgage broker or bank, the loan is bundled with others and sold on the secondary market. This market consists of investors and investment bankers who buy mortgage-backed securities. Banks like Fannie Mae, Freddie Mac, and other large banks buy them in bulk.
After buying these loans, the secondary market turns them into securities or funds, which are then purchased by large institutional investors. These "mortgage-backed securities" were once thought of as a conservative investment as opposed to traditional stocks. As an investment vehicle, these securities would pay dividends based on the interest loans receive.
So what does this have to do with mortgage rates? It’s a comparison game. Investors always search for the highest performing investment. If stocks are comparatively strong, loans must have higher interest rates to compete and attract investors on the secondary market. When bond and stock yields are low, interest rates can be low, to keep pace with consumers’ desire for cheaper loans. It is a balancing act in which banks try to keep rates low enough to attract borrowers, but high enough to satisfy investors.
The pendulum swings the other way when the secondary market expects the Fed to lower rates. Investors start buying up bonds while the rates are higher, creating lower demand for mortgage securities, allowing interest rates to fall once again.
The Fed's Role
This brings us to the role of the government and its policies in controlling interest rates. As stated earlier, the Federal Reserve does not directly control mortgage rates. The rate the Fed sets has to do with the rate banks pay to borrow from each other to meet minimum on-hand cash requirements set by federal banking regulations. Even then, the rate only recommends a target rate. The banks negotiate the rates between themselves.
Lowering or raising this rate helps to address changes in daily economic activity. Lower rates help banks make certain loans more cheaply, which can help generate economic growth. Higher rates will have the opposite effect, slowing the economy down and retarding inflation.
Often, the expectation of what may happen, not what actually happens, is what affects investor responses. Investors continually seek to be the first in when a good opportunity arises, so they frequently act on predictions of what may happen.
The Fed may also take special measures outside of its daily role. When lending stalled because the secondary mortgage market no longer trusted mortgage backed securities, the Fed installed a program that purchased $1.25 Trillion worth of Mortgage-Backed Securities to drive up demand. With fewer of the securities on the market, the value of those that remained on the market increased, spurring demand.
When the secondary market is willing to purchase mortgages from banks again, money flows back to the banks so they have cash to lend again. Some banks have been slow to begin lending to capacity again, afraid they may not be able to sell the mortgages on the secondary market. As the economy recovers, more individuals gain the confidence to take out a loan and buy up some of the additional real estate supply on the market. As these new, healthier loans hit the secondary market, investor confidence will increase, resulting in more confidence from banks as well. Eventually, the banks will be lending to capacity again.
Mortgage rates can also be driven by inflation. This is because rising inflation reduces returns for investors, when looked at in terms of spendable dollars. If an investment returns $100, that money had much strong buying power in 1960 than it does today. In this way, inflation reduces the return on an investment.
The economic pace also affects rates. A sluggish economy hurts homeowners’ ability to pay mortgages, affecting the entire cycle of cash flow. In addition, there are influences that come from capital markets and overseas relationships.
The loan to secondary market to investor cycle has had the strongest affect on mortgage rates in the US in the past five years. When investor demand dries up, the entire chain is affected with lower interest rates being the final result.