Have you ever wondered how mortgage lenders set their interest rates each day?
Are you shopping for a mortgage and can’t seem to get your arms around how and when mortgage companies decide to change their rates?
From the outside looking in, it might appear there really is no rhyme nor reason other than mortgage lenders trying to compete with one another, after all, mortgage rates from one lender to the next are very similar if not the same. But there is a method to this madness and once explained it can give you a clearer picture on why mortgage rates change when they do.
Buying and Selling Stocks
This might get a bit too technical but explaining the differences between various types of investments fall into two basic categories for most investors- stocks and bonds. When someone buys a stock or invests in a mutual fund with a mix of publicly traded corporations they expect to get a return should they sell the stock later on. A stock is mostly based on a company’s profitability as well as expectations of future performance. There is no shortage of stories about someone picking out a stock that tripled in value almost overnight or someone else getting in on an Initial Public Offering, or IPO. And there are just as many stories about someone who lost nearly everything they invested in a stock due to the company’s performance.
Investors can do their research on a company and try and play the market-guessing game. Consumers can make money investing in stocks just as easily as losing money. Just log onto any financial website and you’ll undoubtedly find articles written by so-called experts who take opposite sides on the very same topic. One article might be a prediction of a stock market boom and consumers had better put more money in stocks while another prognosticator warns of a stock market bubble that will soon burst and it’s time to pull money out of stocks to avoid future losses.
The Safety of Bonds
And when investors do pull money out of stocks they can decide to keep those funds in a cash account but more often invest in bonds. Bonds don’t provide as much income as a stock can but they do yield more than money just sitting in a bank account. Bonds don’t provide income based upon performance but they do provide income based upon its yield to the investor.
When an individual investor buys a bond such as a U.S. Treasury or a Savings Bond, the investor knows exactly what they will get when the bond matures. A 10-year Treasury bill matures in 10 years, for example. A 30 year Treasury in 30 years and so on. Today for example the 10-year Treasury would pay around 1.75% of the amount invested over 10 years. That may not sound like very much but for investors it’s much better than losing money. Bonds provide a level of safety that a stock cannot.
When someone buys a bond they don’t have to hold that bond to maturity, they can in fact sell it in the open market. Again, the buyer in such a transaction will know what the bond will be worth at maturity and makes a buying decision based upon that information. The seller of a bond doesn’t want to wait that long and will sell the bond at a discounted rate to take some profits now, albeit small ones, instead of holding the bond to maturity. Bonds carry a specific value and if the price goes up the yield to the investor must fall accordingly.
If more investors believe the economy is slowing down there will be a greater demand for bonds, pushing up the price for the bond and decreasing the yield. As the price of a bond rises the yield falls accordingly. If investors see the economy improving they will sell bonds and buy stocks. A lower demand for bonds means the yield must rise to attract investors.
Okay, so which is better, stocks or bonds? The thinking is that when the economy appears to be on the mend and corporate profits are soon to come then it’s time to buy stocks. When the economy appears to be slowing down, it’s time to sell stocks, reap the profits and invest in bonds. That’s the general idea. The key lies in correctly identifying a trend. And no one truly knows how to do that perfectly. Stocks or bonds. Or Mortgage Bonds.
Lenders price their mortgage rates every day based upon the appropriate mortgage bond. For example, a 30 year fixed conventional mortgage rate is tied to a publicly traded mortgage bond labeled 30YR
FNMA. A 15 year conventional is tied to the 15YR FNMA, and so on. Government-backed loans such as VA, USDA and FHA mortgages have their own bond. A 30 year VA loan is tied to a 30YR GNMA. GNMA is the acronym for the Government National Mortgage Administration.
It’s important to note there that rates are not tied to a 10-year Treasury or a 30-year bond. Even some of the most well-known financial and investment sites have writers that explain, incorrectly, that rates are tied to the 10-year in the midst of an article. That’s simply not true. There will be some correlation but mortgage companies don’t follow any government debt.
Because rates are adjusted based upon the performance of these mortgage bonds which are bought and sold throughout the day, should investors believe the economy is slowing down they will buy bonds, mortgage bonds should they so choose. If the economy looks like its heating up investors will likely sell bonds and invest in stocks for a greater return.
Strong economy, buy stocks. Weak economy, buy bonds.
The Impact of Economic Reports
Now it makes sense to see why investors pay so much attention to economic reports as they are released. A particular report can have an impact on whether or not bondholders buy more bonds or sell them. Remember that the greater demand for a bond, the higher the price, lowering the yield. So, if a report that points to a slowing economy is released some morning you can expect interest rates to fall slightly.
For example, the Census Bureau releases its monthly Unemployment Report and jobs data. Maybe the actual rate stays very near its previous mark but looking deeper into the numbers shows that 300,000 new jobs were created. That’s good news for the economy and signals economic growth. It’s time to buy stocks and sell bonds. When there are more sellers of bonds than buyers the price has to fall to attract investors which will also cause the yield to rise. Fewer buyers of bonds mean higher rates.
Now let’s look at another report the following week. Let’s say the Gross Domestic Product or GDP report comes out and shows the economy actually contracted in the previous quarter instead of expanding. That’s a sign the economy is weakening. So guess what? That’s right, investors sell stocks and seek the safety of bonds, including mortgage bonds, causing the price to go up and the yield (rates) to go down. I very volatile times, mortgage lenders can change their published rates during the course of a business day.
Mortgage companies have a specific department within their organizations that do nothing but track these various indexes and make interest rate adjustments as needed. Because lenders set their mortgage rates on the very same set of indexes, rates from one lender to the next will be very similar. This is also why you can get an interest rate quote from a mortgage company one day and the very next day the rate changed. It’s not because the lender just decided to raise rates one day but because the mortgage bond it is tied to changed.
By now you might have guessed the Federal Reserve, or the “Fed” doesn’t change mortgage rates. The Fed does change what is called the Federal Funds rate and subsequently the Discount Rate. When the Federal Open Market Committee, or FOMC meets every six weeks or so one of the items of discussion is whether or not to lower, raise or keep the Fed funds rate the same. The Fed funds rate is the rate banks can charge one another for overnight lending. Banks have specific cash reserve requirements they must meet every day and if they’re short on funds they have to borrow some. This is the rate the Fed changes.
Why does the Fed change this rate?
It affects the cost of money. When the cost of funds is low then banks are more likely to make more loans, stimulating the economy. When the cost of funds is relatively high then borrowers are less likely to take out loans. At least that’s the theory.
The Fed looks at the cost of money in another way and that is the expectation of inflation. If there are any signs of inflation down the road the Fed would consider raising rates to stem the tide of higher prices. When the economy is really chugging along, businesses can then charge more for their goods or services. More people are employed and they’re making good wages. More money chasing the same amount of goods and services means inflation is on the horizon. Inflation is an enemy to bonds, including mortgage bonds.
Simply because the yield at maturity will be paid in current dollars and inflation eats away at the value of the bond.
When the Fed announces an increase in the Fed funds rate investors can surmise the economy is improving and there is good news ahead on the economic front.
Buy stocks, sell bonds. The reverse is therefore true as well. If the Fed decides to lower rates it’s a signal there’s trouble ahead. Buy bonds, sell stocks.
Now you know how and why mortgage lenders change rates. They have to be competitive with one another to stay in the market but they also tie their interest rates to the exact same index. We have been in a low-rate environment for quite some time and have enjoyed some very low financing costs. Low rates means more people can qualify for a mortgage and finance a bigger home but when rates start to rise, it’s because investors are betting on the future.