Understanding Interest Rate Movements

Why Mortgage and Other Loan Rates Rise and Fall

Understanding Interest Rate Movements
April 18, 2014

Do loan rates seem to change without reason? Like gas prices, it sometimes seems as if interest rates are set by one guy in a dark room with a dartboard…and only one dart.

However, just like gas prices, interest rates really do rise and fall for reasons – many of them complex, some of them unseen by the public, and a few of them irrational. We will not attempt to explain gas prices, but we can go over some of the factors that influence interest rates.

  • Inflation – Interest rates represent the cost of borrowing money. Since inflation means that money borrowed now is worth less at payment time, interest rates will go up to compensate for the difference.

  • Demand – To continue with the gas analogy, classic supply-and-demand applies to loans just as it does to buying gas. When any market is booming and demand for loans from borrowers is high, or the money supply for lenders to lend is low, interest rates will increase. With low demand or plentiful money to lend, rates will decrease because lenders must compete for scarce borrowers and/or compete harder with other lenders.

  • Government Policies – These can range from industry-targeted legislation to mortgage-specific backing programs like FHA and VA loan programs, or broader economic programs like the Federal Reserve's bond-buying stimulus program.
    Bond yields (not bond prices) tend to correlate with mortgage rates. When bond yields are high, mortgage-backed securities must offer higher returns to attract investors over 10-year treasuries. Mortgage rates must increase to increase investor returns. With low bond yields, the opposite effect occurs. The Fed's bond buying keeps prices high and yields (and therefore interest rates) low.

    Bonds affect fixed rates more, since both are long-term. Adjustable loan rates are affected more by the prime rate, which is generally set by the federal funds rate – the short-term loan rate that banks charge to each other.

    Another example of other government intervention is the Dodd-Frank Act, which does not directly affect interest rates but does establish new guidelines and qualified loan definitions, thus altering supply and demand indirectly.

  • Secondary Mortgage Market – Many homeowners do not realize that banks don't always hold loans. They often sell your loan to third-party investors known as aggregators, who package your loan with many others and sell these as mortgage-backed securities.

    Mortgage-backed securities generally compete with 10-year Treasury issues for investor dollars. Thus, these investors define the demand for mortgage-backed securities and the mortgages to back them. Interest rates, to a certain degree, respond to that demand.

    Currently, the Federal Reserve is buying mortgage-backed securities (along with bonds) as a double-strength dose of medicine to keep mortgage rates down – which leads us to the next factor.

  • Perception – There really is a psychological component to interest rates. Bad economic perceptions or anticipation of government policies that may or may not happen can produce interest rate changes through mass behavior. If everyone is scared to buy a house or a car, the demand for loans will decrease and rates will drop.

  • Risk – Finally, we get to a factor that involves you directly. How much risk do you represent to the lender? If you have poor credit history, or are asking for money disproportionate to your income and debts, you will be charged a higher-than-market interest rate because of the non-payment risk you represent. You can check your credit score and read your credit report for free within minutes using Credit Manager by MoneyTips.

These are a few of the many factors that affect interest rates. They are not always straightforward and predictable, but we hope that we have shined at least a small light on that lonely man and his economic dartboard. Now about those rising gas prices….

MoneyTips is happy to help you get free mortgage and refinance quotes from top lenders.

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