Mortgage Rate Primer

One of comments I hear a lot from the public is “The Fed lowered mortgage rates so the market should be better”.  At the risk of wading into economics, a subject most people find about as interesting as watching paint dry, it is important to clarify how mortgage rates work.

Simply put… the Federal Government does not control mortgage rates.  However, the Federal Reserve (“the Fed”) does set the Federal Funds Rate, which is a bell weather rate that banks charge to lend funds to other banks on an overnight basis.  This interest rate influences short term rates such as the prime rate, as well as consumer loans and credit cards.  More importantly, it signals the Fed’s outlook on the economy and inflation, and impacts the broader investment environment.

The Fed acts as the driver of the economy, using monetary policy as a gas pedal or break depending on conditions. They accomplish this by lowering or raising the Federal Funds rate.  When the economy is slowing, the fed can lower the Federal Funds rate to stimulate the economy.  When the economy is too robust or inflation is higher than their target, they can raise the Federal Funds rate to slow economic growth and (hopefully) tame inflation.

The mortgage market is not controlled by the Fed, but rather is essentially a bond market driven by investors and the rate of return (interest rate) they are willing to accept when taking into account inflation and the long-term economic outlook. Mortgage rates most closely track the 10 year Treasury market.  As we have seen, even though the Fed recently lowered the Federal Funds Rate, average mortgage rates have risen by about .75% since the beginning of October.  How can this be?

One word… inflation. The answer is investors are simply not convinced inflation will hit the Fed’s target rate of 2%, so they will demand a higher rate of return to offset the effects of higher inflation. If investors think that lowering the Federal Funds Rate will fuel more inflation, they will demand higher returns in the form of higher interest rates.