With the Federal Reserve Board (Fed) lowering interest rates, there’s a lot of conversation about refinancing home mortgages. When consumers hear that the Fed lowered interest rate to near zero, they think that they can get a zero interest home loan. Unfortunately, while Fed interest rates may influence your 30 year mortgage, it’s really something else that drives your mortgage’s interest rate.
In this article, we explain what drives mortgage interest rates. Then we will look at how the Fed’s changing interest rates is an indicator of what might happen to home mortgage rates.
Mortgage Interest Rates and Treasury Notes
To understand why mortgage rates fluctuate and how the Federal Reserve’s interest rate policy influences mortgage interest rates, we first need to understand Treasury Notes. A Treasury Note, or T-Note is a government issued I Owe You (IOU). The government, sells these IOU’s to investors looking for safe investments.
For example, let’s suppose I offered to sell you a promissory note (an IOU) that said I would pay you $100 after one year, and it was secured by the US government. Let’s also assume that the promissory note pays zero interest.
You probably wouldn’t be interested if I asked you to pay me $100 now for the IOU, even if I promised to pay you back at the end of the year. You would have nothing to gain loaning me $100 for an entire year. However, what if I was willing to sell you the IOU for $80? Now you might give some serious consideration to my offer. Especially as I’m willing to pay you $20 more at the end of the year, than what you would pay for it now. Even though it’s a zero interest loan rate, because you can buy it at a discount, you can make a profit of $20.
Understanding Yield and Mortgage Interest Rates
The difference between what you paid, and what you receive when I pay you back is called yield. The more you’re willing to pay for my IOU, the lower your yield. If you can buy my IOU for less, the higher your yield will be.
Continuing with our example, what if I wanted $99 for my IOU today? Remember, I’ve promised to pay you $100 at the end of a year. You’d probably say, I’d be better off putting my money in the bank or investing in the stock market. You would have to pay too much for my IOU for too little yield.
But, what if the banks aren’t paying decent interest and the stock market was doing poorly? What would you be willing to pay for my IOU? Ninety-nine dollars might be too much, but would you be willing to pay $90? At an 11% yield, (10/90=.11) you would probably give serious consideration to my offer. Especially, since it’s substantially higher than you get at your local bank and the stock market is doing poorly.
Why I Might Shop my IOU
However, if I’m smart, I’m going to shop around to see who might be willing to pay me more for my IOU. I might even do an auction and sell my IOU to the highest bidder. If I can get someone to pay me $95 instead of $90 for my IOU, that means more money for me. It will cost me less in the end, and that buyer would receive a 5% yield (5/95=.05). The more someone is willing to pay me upfront, the less it costs me. But it’s a smaller yield for the buyer of my IOU.
Bills, Notes and Bonds – Oh My!
If the stock market and banks were paying very little or weren’t doing well, would you be willing to pay more for my IOU? Investors are. When the stock market and banks do poorly, investors look for safer, higher returns. And some investors turn to buying government backed IOU’s, better known as government securities. These government securities, come in range of durations, or maturity dates. Some are repaid in months, while others are repaid over 30 years.
Securities that are repaid in a 12 months or less, are call T-Bills, while securities that are repaid over 2 to 10 years are called T-Notes. Securities that are paid off over 20-30 years are call T-Bonds. (See differences between bonds, notes and bills.)
What if an investor is looking for an investment longer than one year, say 10 years? This investor might invest heavily in securities that are repaid in 10 years. A 10 year T-Note is just like a one year IOU, with one major exception. Any government security with a maturity date longer than one year, also pays interest.
Why Home Mortgage Rates are Driven by 10 Year Treasury Notes
On average, most homes are either refinanced or sold every 7-10 years. Because of this, when investors consider buying your home loan, they are simultaneously looking at 10 year T-Notes and using the T-Notes as a benchmark.
The investor may ask themselves, which is safer? Is it safer to invest in a home loan, secured by a deed of trust, or the Federal government? The investor has to decide, how much they’re willing to pay to buy a home loan versus a 10 year treasury bill compared to the risk and yield. The more investors are willing to pay, the lower their yield. Because of this connection, home mortgages are closely tied to the 10 Year Treasury Note.
The Myth Connecting the Fed Rate to your Mortgage Rate
So why the big deal about the Fed Rate?
The Federal Reserve is responsible for keeping our economy going. When inflation is rising, their job is to slow it down. When the economy is struggling, their job is to put more money into circulation, so people will spend more. They have two tools that they regularly use to do this: the interest rate banks charge each other for overnight loans and buying and selling IOU’s.
The Fed Rate is only a Symptom of the Broader Market
When the economy is doing poorly and the Fed lowers interest rates, it grabs the headlines. But what is really happening? When the economy falters, investors start looking for safer investments. What could be safer than a government IOU? But government securities are sold at auction, just like my IOU. So, if the economy is booming, investors may only be willing to pay $900 for a 10 Year Treasury Note, because they can make more money in the stock market or other investments. As a result, home mortgage rates go up. But if the economy is doing poorly, investors may be willing to pay much more for my government IOU, even as much as $990. After all, some profit is better than none, right?
When the Fed announces an interest rate change, it is only a symptom of what is already happening in the market. Investors are either worried or exuberant. When they’re worried, they’re fleeing stocks and buying safer investments like 10 year Treasury Notes. However, because of the competition, they’re paying more for them than they might in a good economy. But because they’re paying more, their profit or yield is less. Because of the close correlation between 10 year note rates, and mortgage rates, this translates to lower interest rates being available for home loans.
If your looking to refinance your home loan, check out How to Get the Best Interest Rate for your Home Loan.