Some things are well known, some things aren’t. For example, there are approximately 5,000 U.S. stock market indices, but the three best known are the S&P 500, Dow Jones Industrial Average, and Nasdaq Composite.
Some things make the headlines, some things don’t. An interesting topic for mortgage applicants is “interest rates.” The generic topic certainly makes headlines, especially when the Federal Reserve is changing its strategy and adjusting its approach to economic stability by potentially moving interest rates in 2022.
But what is meant by “interest rates” and how do mortgage rates move in relation to interest rates in general?
What’s an interest rate, anyway?
In its simplest form, an interest rate is the amount a lender charges a borrower. It’s communicated as a percentage of the principal (the amount loaned).
For instance, a 5% rate on a $100,000 loan would yield the lender $5,000 per year or around $416 per month (assuming no principal decrease).
The interest rate on a loan is typically noted on an annual basis. One might commonly hear, “My mortgage is at 3.50 percent,” or “I bought a municipal bond that pays me 2.50 percent tax free.” If someone is paying an interest rate, they’d want the lowest rate possible. If someone is receiving income from a certain security based on its interest rate, they would want the highest rate possible.
All of this begs the questions, “Why are there different mortgages rates, and specially, why are mortgage rates higher than the rate on securities issued by the United States Government (known as Treasurys)? And do interest rates all go up or down together?”
What determines an interest rate?
Without listing them, there are thousands of securities that pay various interest rates, and thousands of payers (including individuals) paying various rates. In general, interest rates vary based on:
- Supply of money
- Demand for that money
- The risk of the payer not paying (for example, the U.S. Government versus your out-of-work brother-in-law)
- The amount of time is involved (a loan overnight versus one that lasts 30 years)
And even similar instruments have different rates. For example, a 30-year fixed-rate mortgage offered to one borrower may have a different rate than another based on the borrower’s credit profile and amount of the loan versus the property value.
When looking at interest rates, in general, many of them move together, seemingly up one day, down the next. Some rates are “tied” together.
Say the City of New York has issued several billion dollars’ worth of bonds in the last several years. It suddenly suffers an economic downturn that impacts its credit-worthiness. The price of all its bonds will suffer. Conversely, if Dallas discovers oil under city property, its economic prospects improve dramatically, improving the credit rating of its outstanding bonds.
From the perspective of the United States of America, the economic picture that our Federal Reserve watches is much more complex. The Federal Open Market Committee (FOMC), which carries out the actions requested by the Federal Reserve, looks at economic reports at the nationwide, state, and local levels. The important thing to remember is that the FOMC is watching the same measures that economists and investors do. And therefore the same factors that drive decision making by the Federal Reserve (inflation, employment, and the health of the housing market, to name three) also drive the decision making of investors and analysts. It is not the Federal Reserve setting rates, but economic events pushing all interest rates up or down.
How are Treasury yields and mortgage rates related?
That said, Treasury yields can affect interest rates. The United States Government has never defaulted on its debt, and is viewed as “risk free.” The Government pays its debt on time, at the agreed upon amount, and until the debt is paid off. The United States does not pay off its debts early, and the likelihood of it not paying its debts is miniscule. Investors who want a steady and safe return compare the interest rates of all fixed-income products, including that issued by the United States, and decide what to own in their portfolio.
The goal is to get the highest return on investment with the lowest amount of risk.
There are two primary differences, however, between debt issued by the U.S. Government loans and loans where homeowners are making their monthly payments that cause mortgage rates to be higher than Treasury rates.
- Borrowers are able to pay off their mortgage early. The chance of this happening causes investors in securities backed by mortgages, aka, mortgage-backed securities, or MBS, to require a slightly higher premium.
- Perhaps the more important reason that mortgage rates are higher than Treasury rates, is the chance of defaulting. More specifically, investors believe that the odds of a missed payment by the U.S. Government is nearly 0 percent. Throughout history, individuals, and families, however, miss a payment or default for a variety of reasons: small savings, a lost job, or an unexpected necessary expense. Yes, the risk might be small, and lenders underwrite every loan analyzing borrower’s history of payments.
Over time, economic conditions shift, unemployment and inflation go up and down, and the Federal Reserve and investors will act and react accordingly. Treasury rates and mortgage rates don’t affect each other, but instead, each are impacted the same economic conditions.
And both will make the headlines.