What causes mortgage rates to rise or fall? How does inflation factor in?

4-8-2011

The answer is..... "everything" and "a lot"!

There are many reasons and many variables that attribute to mortgage rates moving up or down. Some of those variables include the stock market, mortgage backed bonds market, global and national news and inflation.

The 10 year treasure bond is noted as being the best determination of whether mortgage rates will rise or fall. Most mortgages are amortized over 30 years and the average mortgage is either paid off or refinanced within 10 years. Treasury notes are backed by the faith and credit of the United States which makes them the standard benchmark. When the bond rate yield goes up (bond price goes down) the interest rates will rise as well.

Another factor is the demand for loans.

Inflations is another huge factor. What is inflation? Inflation is the value your money can purchase over a period of time. Inflation is when your dollar purchases less then next year. If you can purchase gas at $3.25 per gallon now and in one year's time the gas prices increase to $3.85 per gallon there was inflation of 60 cents per gallon or about 15%. Conversely, deflation is when your money can purchase more the next year. What is an example of inflation? Let's say you are 10 and you mow the lawn for your mother for $1. You put that dollar under your bed and wanted to save it for college in 8 years would your dollar be worth more or less? The answer is it would be worth the same, but the real question is would you be able to purchase more or less? The answer is less. Why because of inflation. If there is an average inflation rate of 4% every year for those 8 years that would equal 32%. If the cost of a candy bar was exactly $1 when you are 10 and their is 32% total inflation over the next 8 years then when you are 18 that same candy bar would cost $1.32 and you would not be able to purchase it with your saved dollar. Think about what this would do to your retirement account and the cost of living. Instead of a candy bar what about your monthly budget. If you spend $48,000 on living expenses every year then in the example above your expenses would now cost $63,360 which is a $15,360 difference. That's why at a minimum you want your investments to earn more than the inflation rate. If you have $100,000 in the bank and you earn 4% interest on your money and there is 4% inflation your $100,000 will purchase the exactly the same.

Ok I get inflation but how does my mortgage tie into this?

If there is massive inflation what would happen to interest rates? They would rise. Why? Let me give you an example. If ABC bank gave you a 30 year loan for $200,000 at 6% interest they would expect to receive $12,000 in interest every year over the next 30 years (of course if you paid the principal down their 6% equal less than $12,000). Let's say that ABC bank wants to spend their $12,000 investment on gas every year. At the end of year 1 if gas cost $3.25 per gallon they would have 3692 gallons of gas. At the end of year 2 if there was a .60 cent increase in gas and it now costs $3.85 per gallon their same $12,000 would allow them to purchase 3116 gallons of gas which is 575 gallon deficit from the previous year. To sum it up when ABC banks receives the same 6% return every year from your 30 year fixed mortgage their investment return would actually return them less money or goods when their is inflation, such as gas. What does the bank have to do as a result to still earn a true 6% return? They have to increase the rate to account for the rise of inflation.