I am Peter Thompson, My goal is to take the mystery out of the home buying and mortgage process, and help home buyers understand their options.

Why do mortgage rates change?

I always get phone calls when the Federal Reserve Bank (The Fed) changes the interest rates. Most people assume that a change in the Fed rates will mean a change in the rates charged for mortgages. There is some truth in that, but it isn’t a direct connection.

The Fed affects short term interest rates by setting the Federal Funds and the overnight lending rate. These rates directly affect how much it costs for banks to borrow money. So when the rates go up, banks immediately pass them on by increasing their prime rate. This is the best rate they charge their customers. It’s not unusual for these rates to stay the same for months at a time.

By contrast, mortgage rates change every day. These rates are set more by supply and demand, the same way as the prices move up and down in the stock market. Traders buy and sell mortgaged backed securities, which are similar to long term bonds. Most mortgage lenders price to this market, so interest rates for mortgages change based on what is happening in this market.

When traders buy or sell a mortgage backed security, they are looking into the future and trying to anticipate what is going to happen years down the road. Mortgages are usually based on a 30 year term, but the average loan will be paid off earlier as people either sell their homes or refinance. Traders are usually looking out 5-7 years in the future.

Mortgage rates are most affected by the threat of inflation and the strength of the economy overall. When inflation rises, prices are moving up so it takes more money to buy the same amount of a good or service. To a mortgage holder this means that the borrowers are paying them back in cheaper money. Because of this, they react strongly to any hint of inflation.

When the economy is growing strongly, it is the Fed’s job to keep inflation under control. It does this by increasing short-term rates, which slow down demand and act as a brake on the economy. Generally when the economy is strong, prices tend to increase. So if there is good news for the economy, it is bad news for mortgage rates. On the other hand, bad economic news tends to make the rates go down.