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Although mortgage interest rates dipped to a one month low this week, they’re still significantly higher than they were several months ago. So, why are rates going up if the housing market’s in a slump? Why doesn’t the Fed lower interest rates to encourage a comeback in the housing market?
Well, the short answer is that the Fed doesn’t have much to do with long-term Mortgage interest rates. The Fed controls only one interest rate, the Fed Funds Rate; however, several other interest rates are based on the Fed Funds Rate, so, indirectly, the Fed controls these as well. The most important of these to consumers is the Prime Rate.
The Fed Funds Rate is the rate at which banks loan money to each other; banks make money by charging a premium on this rate when they lend money to consumers. The Prime rate is currently set about 3% above the Fed Funds Rate and is defined by the Wall Street Journal as “The base rate on corporate loans posted by at least 75% of the nation’s 30 largest banks.” Credit cards and Home Equity Lines of Credit are based on the prime rate, which currently hovers around 8.25%. Long-term mortgage interest rates, on the other hand, are set more like stocks and bonds.
Most people assume that when they get a 30-year fixed rate mortgage, the lender they chose holds that loan until it’s refinanced or paid off; either that or the lender sells the loan to another lender soon after funding. This is only partially true and is misleading if you’re wondering about interest rates. The lender to whom you are making payments holds the servicing rights for your loan, but they don’t actually own the loan itself. What does this mean? Well, the lender gets paid to handle the customer service side of the loan, the only side you’re involved with.
Soon after your loan funds, the lender sells the ownership rights to your loan to one of two semi-private, government backed corporations, Fannie Mae or Freddie Mac. These two corporations package your loan with a bunch of others and sell them on the bond market to private investors in the form of Mortgage Backed Securities; to understand the concept, think of Mortgage Backed Securities as company stock sold on the stock market. Stocks represent an ownership interest in a company, whereas Mortgage Backed Securities represent an ownership interest in a group of mortgages. The investors that purchase your mortgage get paid from your mortgage interest payments. Since the interest you pay on a mortgage goes to these private investors, it makes sense that if there is high demand from these investors for Mortgage Backed Securities, interest rates will go down.
I’ll tell a brief story to illustrate this concept further. A couple years ago I was interested in going to a big 3-day music festival down in Tennessee. The tickets went on sale for around $175 a piece, but they sold out in seconds. After they sold out, the only way you could purchase them was on eBay for around $250 a piece. They went up in price because demand was so high; people wanted those tickets, and they were willing to pay a lot more than face value for them. It’s Economics 101; Supply and Demand.
The same thing happens with mortgages. When a lot of private investors want mortgages, it costs more for the investors to purchase them. But when investors are being paid on the interest collected on a mortgage, the lower the interest rate, the worse it is for the investor. So if there are a ton of investors out there buying mortgages, the lender says, “Hey, Mr. private investor, I know you want to make 8% or more on this investment, but there are a million of you out there willing to make only 5.5%, so if you don’t take it for 5.5% I’ll sell it to someone who will.” So mortgage interest rates are now 5.5%. But what happens if there are no investors willing to make only 5.5% on their investment? The lender has to raise the rates to encourage more investment; now rates rise to, say, 6.5% and more investors are willing to purchase mortgages at that rate of return.
So when mortgage rates rise, it’s because, for a multitude of reasons, investors would rather put their money somewhere else. To encourage the investors to purchase your mortgage, rates go up, and vice versa.
To sum up, the Fed only controls the Fed Funds rate, which has little to do with long-term mortgage interest rates. The private investors purchasing your mortgage are driven more by long-term economic indicators.
The private investors purchasing Mortgage Backed Securities are just like you and me; in fact, there’s nothing stopping you from purchasing Mortgage Backed Securities, other than the fact that they’re usually pretty pricey. One of the major factors that affect mortgage interest rates is inflation. If you were interested in investing $10,000, you’d want to maximize your return on that investment. If you knew that inflation was on the rise, you’d want more of a return because if inflation goes up, your $10,000 is worth less. If a company wants your $10,000 investment, they’re going to have to offer you a higher rate of return to make it worth your while. And like I explained above, a higher rate of return on Mortgage Backed Securities = higher Mortgage Interest Rates for homeowners.
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