NMLS # 107614
Following is a very simplified breakdown of a very complex topic. There are many intricate relationships involved and many important factors (market structures, hedging, advance commitments, and others) that haven't been included in the text in order to (hopefully) make it more understandable and useful.
We hear it all the time and the questions are simple enough: What's going on with mortgage rates? What makes them rise, or fall? Is it the Fed? The economy? Inflation? The banks? The President? Fannie Mae or Freddie Mac? Is it a secret conspiracy? The answer is that rates are moved by a number of related factors, and believe it or not, you are one of those factors.
Mortgage money can come from many sources, including deposits at banks and brokerages, but most comes from investors through what is collectively known as the "capital markets." This is where investors interested in purchasing certain kinds of debt instruments -- bonds, in this case -- come to buy these items. In order to attract investors, sellers of bonds must compete with one another to get their money. They do this by offering a variety of " instruments" (also called "product") with differing structures of risk and return over given periods of time. These offerings compete with other investments which are reasonably similar in performance, such as US Treasuries, corporate bonds, foreign bonds, and others.
Who are these investors, and why are they so fickle? Mostly, they're people like you, and you want two opposing things: low payments on your debt, especially your mortgage, and high returns on your investments. You (or your investment advisors or fund managers) will only buy so many low- yielding bonds (mortgage or otherwise), because you'll take your money elsewhere if your returns are too low.Investor demand for a given kind of investment plays a considerable role in moving market yields, because investors have literally hundreds of places to put their money. It's a crowded marketplace, with many sellers of various products competing for those investor dollars. Investor demand for specific product rises and falls with changes in investment strategies; if demand falls enough, a change needs to be made to attract investors again. How to attract them again? Usually, by raising interest rates.
Of course, it's not as easy or simple as that. Mortgage market makers serve not one client, but two: investors, who want the highest possible return on their investments, and the homeowner or homebuyer, who wants the lowest possible interest rate. Simultaneously, rates need to be high enough to attract investors but low enough to attract borrowers. It's quite a complex dance; investors, though, make the music. As interest rates (yields) decline, investment customers can become more or less interested, depending upon the direction of economic growth, inflation, appetite for the given product, and several other factors. Typically, though, the lower those rates get, the fewer investors are interested in putting them on their books.
In the case of financial instruments like bonds, things get a little more complicated. Bonds have an interest rate (yield), a dollar amount (face) and a current price (price). A very simple explanation -- which leaves out a number of very important factors -- would be as follows:
Let's say, for example, that you want to sell a $1,000 (face) bond with a yield of 6%. And let's say that it's a good deal, so ten investors start offering you more than the $1,000 you want. They bid the price up to $1,010 -- $1,020 -- $1,030. In effect, that increase in price is actually borrowing from the interest which the bond will return. Because some of the interest is gone, the actual return to the investor is no longer 6%, but something less than that. When demand for a given bond is strong, prices rise to the seller, and the return to the investor (yield) declines.
Conversely, when demand for a given bond is weak, the price falls. For example, you might have to sell that $1,000 for only $980; and the return to the investor (yield) rises, since the buyer not only gets all the interest on $1,000, but also got a discount on his purchase price.
The principle to remember is this: as a bond price rises, its yield falls, and vice-versa.
Contrary to popular myth, the Fed (more properly, the Federal Reserve) doesn't control mortgage rates. In fact, their most well-known policy tool -- the Federal Funds rate -- is the overnight interest rate which banks charge each other when a bank needs to borrow money to meet end- of-day reserve requirements. Simply, those rules say that a bank must have so much cash on hand when the books close at the end of the day, and those funds can be borrowed from another bank at this interest rate. You should know that the Fed merely "suggests" what that rate should be, which is why it's called a "target" rate; the actual rate is negotiated between the borrower bank and the lender bank.A good way to keep a handle on the Fed is to remember that the Fed Funds rate is the shortest of short-term rates -- literally, an overnight loan -- and a fixed-rate mortgage is all the way at the other end of the scale, a loan that lasts as long as 30 years.The end result is that the Fed raises or lowers interest rates to help address increases or decreases in economic activity. Lower rates can help banks to make certain kinds of loans more cheaply, especially for business and certain kinds of consumer lending, and that can help to generate greater economic growth. Higher rates can cool demand, helping to keep inflationary pressures from forming.In some ways, expectations of what the Fed might do can be more important than what the Fed actually does, as their actions or inactions can help to confirm or deny what investors believe.You may also have noticed that sometimes the Fed cuts interest rates -- and fixed mortgage rates actually rise as a result. Why? If the Fed is taking steps to address economic weakness by lowering rates, that likely means that a return to faster growth -- and possible higher inflation, as well -- is coming sooner, rather than later.
So what moves mortgage rates? Supply. Demand. Competition for money. Inflation. The Economy. Expectations. And you, of course.
We hope that this helps you understand a little better how the whole thing works.
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