In: Root » Legal and finance » Loans and mortgages
Mortgage rates are not set by the Federal Reserve Board or any other government entity. The Fed, among other things, controls the cost of money that banks borrow. Banks borrow money from the Fed and various sources at one interest rate, then mark that interest rate up a notch or two when they lend that money out to their individual and business customers. One of the main challenges the Fed undertakes is controlling inflation. The Fed does so by influencing whether money is more or less expensive to borrow. The more expensive money is, meaning the higher interest rates are, the more the Fed is trying to control inflation. Inflation is a silent killer of an economy. If a farmer agrees to sell 100 bushels of wheat for $1,000 but after 6 months that $1,000 is now worth only $900 due to inflation, the farmer loses money. Businesses lose money. The government loses money. And when someone loses money, the natural thing to do to make up for it is to raise prices. This stokes the flames of inflation. Inflation is such a difficult phenomenon to stop once it gets started, so the Fed tries to make sure it never gets started in the first place. The Fed attempts to control inflation by controlling the cost of funds. It does this by influencing the Federal Funds rate and controlling the Federal Discount rate. The Fed Funds rate is the rate at which banks make short-term loans to each other, usually overnight. For many who don't understand why banks would do that, it's simple if you recall that banks have certain asset-reserve requirements. For every loan it makes, a bank must have a predetermined amount of cash sitting in its vaults. This reserve requirement is a direct result of the infamous bank runs that helped kick start the Great Depression, and sometimes banks need to borrow to have the legally required reserves. The Fed also regulates the Discount rate, which is the amount set aside for short term lending that is issued by the Federal government directly. Banks can also borrow from the Federal Reserve at discounted rates. A rise in lending activity is an indication of a strengthening economy. A strong economy increases the demand for money because more businesses are willing to borrow more to expand. When the demand for capital increases, lenders can charge more and often do. But if the economy is not monitored carefully, inflation can kick in. The Fed looks for signs of an improving economy: lots of new jobs created, lots of new cars being sold, lots of, well, lots of everything good for the economy. If there are too many consecutive signs of a booming economy, the Federal Reserve Board will decide whether to raise the Discount rate at its next meeting. On the other hand, if the economy seems to be going into a slump, or is currently in one, the Fed will do just the opposite-lower the Discount rate. Lower rates make the cost of money cheaper. In turn, if businesses can borrow more money with less cost, they'll be encouraged to expand, hire more people, and sell more goods. Your clients may say something such as, ''Hey, I saw the Fed lowered rates yesterday, what kind of rate can I get today?'' That's not really how it works. Fixed mortgage rates are set by the open markets, specifically mortgage bonds that are bought and sold throughout every trading day. Lenders set their mortgage rates based upon these mortgage bonds, specifically a Fannie Mae or Ginnie Mae bond. As the price of these bonds goes up or down, so do lenders price their mortgage rates. Mortgage rates are tied to their specific index. Thirty-year rates are tied to a 30-year bond. Fifteen-year rates are tied to a 15-year bond. Conventional loans and government loans both have their indexes. And it's these bonds being bought and sold by traders, public and private investors, that set market rates. Since bonds are predictable, the return isn't as sexy. Instead, bond owners invest because of that guarantee. They don't want any surprises. But who would invest in a mortgage bond when there are other investment opportunities that could pay much more? When the stock market is going crazy and it seems that everyone is investing something in stocks to get a great return, then investors typically pull their money out of those staid bonds and use that cash to buy high-flying stocks. Remember the dot-com boom? Real estate? Pet rocks? Betamax? Bonds must compete for those same investment dollars, and when money pulls out of a mortgage bond to chase higher earnings elsewhere, the seller of those bonds must make adjustments to the price of the bond. Less demand means that a lower price will be issued. And a lower price means a higher return, or yield, on that bond. What causes a price to go up or down? Changes in demand. If the stock market is tanking, then investors might want to sell stocks and put more money in the safe return guaranteed by bonds. But if more people want the same thing, then guess what happens? That's right, the price goes up due to increased demand. A bond holder can get more money for the same bond. When the price goes up, the yield, or return, goes down. Every single day, all day long, there is a department at a mortgage company that does nothing except watch the prices of various mortgage bonds to determine how they'll set their mortgage rates for the day. This department is called the ''secondary'' division of the lender, and every mortgage banking operation has one. It's here that rates are set that are distributed to you, the loan officer. As each business day opens, all of these secondary departments watch the opening trading of the various mortgage bonds. If the price of a 30-year Fannie Mae is selling on the open market at the same price as yesterday, then rates on similar mortgages for that day will probably be the same. If the price of the bond goes up, the yield then goes down, meaning rates get lower. If there is less demand for a mortgage bond, the yield goes up, raising mortgage rates. This goes on all day long. And mortgage prices change constantly. Mortgage bonds are priced in basis points. One basis point equals 1/100th of a percent. The secondary department must be wary of any bond-price swings throughout the day. If the price of a particular mortgage bond moves by just a few points, say three or four, the secondary department will usually not change rates. If, however, there is a move in price of, say, 15 or more basis points, you can expect the lender to make a price adjustment. Different lenders may have different thresholds for price changes, but most will start to get nervous if bond prices move significantly one way or another. You can bet that if bond prices change by 20 or more basis points there will be a midday rate change. Mostly, the rates themselves won't change as much as the cost to the consumer will change. For example, if a borrower can get a 6.00% loan by paying a one-point fee and mortgage bond prices fall by 50 basis points, lenders will typically adjust the rates to 6.125% or charge an extra half-point fee to get the 6.00%. Don't confuse basis points with discount points. They're different. Secondary departments watch mortgage bond pricing and the effects of various economic and political events that might trigger a bond selloff or a bond rally. For example, did the latest unemployment numbers show strong job gains? Then one can expect money to move from bonds and into stocks. That means higher interest rates.
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