How Are Mortgage Rates Derived?

You can’t avoid news about interest rates lately, and there’s been lots of questions about how mortgage rates are actually derived. So let’s go beyond the headlines and help you better understand rates. Whether you are truly interested, or just want some good cocktail party tidbits, we hope you find this useful. Just be aware that these explanations are greatly simplified as an Interest Rate 101 primer.

Also, it’s important to understand that, whether we see higher rates by August or they hold until 2005, the low rate cocoon we’ve all been living in has to break. It’s a market inevitability. Knowing it’s a market inevitability takes some of the sting out of rising rates. And for many homebuyers, a rate increase will help you by taking overly-leveraged competitors out of the market.

What The Talking Heads Are Talking About
Most of what you hear in the news is about the Fed Funds Rate. This rate, currently at a record low of 1%, is what America’s 12 Federal Reserve banks charge each other on overnight lending to balance their reserves each day. It serves as a short-term cost-of-money benchmark for businesses and consumers. It is low relative to business and consumer lending rates because the Fed banks are government-backed and therefore a good credit risk. As consumers, the rates we get for cars, credit cards, etc. are higher than the Fed Funds Rate because our lenders price funds to compensate themselves for the risk they’re taking on our creditworthiness. If short-term money is too cheap, prices in the economy rise too fast and cause inflation. The Fed’s job is to anticipate when inflation is a threat and slow it down by raising the benchmark Fed Funds Rate.

How Traditional Mortgage Rates Are Derived
Contrary to popular belief, long-term, fixed mortgage rates (e.g., rates on 30-year fixed loans) are not tied to the Fed Funds Rate. Instead, they follow the yield (rate of return) on mortgage backed securities issued by Fannie Mae, Freddie Mac, Ginnie Mae and private investment banks. Each trading day, investors use economic data, war news, etc. to determine their risk tolerance. If this market information signals economic improvement, as we’ve seen recently, investors sell mortgage bonds to buy more risky assets in search of better returns. This selling sends bond prices down and yields (rates) up. When this happens, banks who make consumer mortgage loans raise their rates.