This article is a basic explanation of how and why mortgage rates change. For someone that is getting ready to buy a home and apply for a mortgage or are thinking of refinancing an existing mortgage, where rates are a primary driver when deciding whether or not to refinance, they might wonder why rates are at one point this week and a bit different the next. Do lenders have a system they refer to when setting interest rates for mortgages or do they just compete with one another and try to have the most competitive rate?
There are two types of loan programs, fixed and adjustable. An adjustable rate loan is tied to a specific index and adds a margin to it. For example, a common index might be the London Interbank Offered Rate, or LIBOR. Let’s say the 1-year LIBOR is 2.50 and the margin is 2.00. By adding the two together, the new rate until the next adjustment is then 4.50%. Interest rates for an adjustable rate mortgage change when the index changes as the margin will never change. The LIBOR is the average of interest rates prominent banks in London charge one another for short term lending. LIBOR is the equivalent of our Federal Funds rate.
Fixed rates are also tied to a specific index. A 30 year fixed conforming rate is typically tied to either the FNMA 30-yr 4.0 mortgage bond or Freddie’s version of FHLMC 30-yr 4.0. VA loans have their own index for a fixed rate called the GNMA 30yr as well. Each day as these indexes are released, lenders set their rates accordingly and all lenders follow the same general set of indexes. Okay, so how do these indexes change?
You might have noticed the indexes are also bonds and act just like any other bond. A bond provides an investor a fixed return. When someone buys a bond, the return is known in advance. Bonds provide stability for investors and not purchased for greater returns compared to other investors. Investors who seek greater returns buy stocks or mutual funds, for example, not bonds.
When investors think the economy is headed for a slowdown, they can pull money out of more volatile stocks and into the safety of bonds, including mortgage bonds. When the demand for bonds increases the price increases accordingly while at the same time lowering the yield on the bond. So how do investors gauge the economy? What do they look for?
Each day, some economic report or piece of data is released by the federal government or other bureaus. Some economic reports will have a greater impact than others while some reports have very little, if any impact at all. What reports are important and which are less so as it relates to mortgage rates?
One of the more notable reports is the Unemployment Report, or more specifically, the number of new jobs created. While the unemployment rate can fall, a good indication of a healthy economy, buried within that report is the number of non-farm payroll jobs created in the previous month. When employers hire more workers, that’s a solid indication of a growing economy. Mortgage bonds can react negatively to this as investors pull money from bonds and back into stocks.
Also noted in the unemployment report is payroll data. As employers begin to compete with one another for employees, they’ll soon have to pay them more. When wages go up, it’s another sign of a healthy economy.
But that leads us to another important piece of data- inflation. The theory is that when consumers have more money in their pockets they buy more goods and services. And when businesses see an increased demand for their goods or services they can charge more. This results in inflation and decreases the value of the dollar. Housing starts is also paid attention to. So too is Consumer Confidence, Durable Goods Orders as well as minutes from the Federal Open Market Committee meetings.
What reports really don’t have as much of an impact? The number of mortgage applications is released for the previous week and month but really don’t have that much of an impact. Retail Sales is relatively important but not nearly as much as employment numbers. Construction Spending is a routine report that doesn’t have a significant impact. There are others but the primary ones that affect mortgage rates come on the first business Friday of each month- the data released in the unemployment report.