What's the Deal with Rising Mortgage Rates?

Mortgage rates continue to be in the news and are weighing on the minds of some homebuyers. Earlier in the month we looked at the dollar impact of higher rates (http://www.amybergquist.com/blog/2007/06/14/rising-mortgage-interest-rates/). The final result was that the changes we’ve seen over the course of this year (6.25% to 6.75% on a 30 year fixed) have resulted in monthly payments increasing by about $33 for every $100,000 borrowed.

Since that post, rates have stabilized and even come down a little, though there remains a good deal of uncertainty about which way they move next. Rather than speculate on the direction of future rate changes, let’s talk about how mortgage rates are set and why they are changing.

Mortgage rates are set by global financial markets – millions of investors around the world – and the US government. Investors are constantly evaluating the world economy to determine if buying your mortgage is a good investment in terms of risk and return. Since you lock in your mortgage at the time of purchase (or refinance), the rate you pay is what investors feel is the appropriate return for the risk of lending to you. Investors do the day-to-day pricing, but the US government has a big say in the direction and level of rates as they make periodic adjustments to keep the US economy growing at a consistent pace.

Interest rates go up when investors feel that risks are increasing. This year, there have been two main risks that have investors worried; inflation and mortgage lending practices. Inflation is when stuff gets more expensive (for example gasoline). Some inflation is healthy, but if it gets too high the US government starts to raise the Federal Funds rate, which in turn causes all other rates to rise too. The US economy showed signs of inflation during the first half of the year, so investors are concerned that the government might raise rates after holding them steady for over a year.

Mortgage lending practices are the other source of risk, specifically to subprime borrowers (those with poor credit). A sharp rise in the number of homeowners who are late on their mortgage payments has investors worried that they underestimated the risk of the mortgages over the past few years. This has called into question the trustworthiness of the mortgage brokers who wrote the mortgages and led to concerns that all borrowers are more risky than they originally appeared.

Interest rates have stabilized at current levels because there is a large group of investors who think that US government is more likely to lower interest rates than raise them. These investors believe that the US economy is slowing down and headed towards a recession. The government would try to preempt a recession by lowering interest rates in hopes of generating more economic activity.

So that’s the current situation; some believe that rates should be higher, others that rates should be lower. Trying to guess what will happen next doesn’t seem like a very productive activity since even the professional investors disagree. Homebuyers shouldn’t let mortgage rates stop them from participating in the current real estate market because the dollar impact is modest. Although the cost of borrowing money is no longer historically cheap, it is still very reasonable and fluctuating in a narrow range. We should just be glad that it’s not the 1980s, when mortgage rates were at or above 10% for the entire decade, peaking at over 18% in 1981.

See the historical trends for yourself at http://mortgage-x.com/trends.htm. The historical graphs are near the bottom of the page.