Mortgage Rate Influence

What causes interest rates to rise and fall? Directly, mortgage back securities pricing causes fluctuations in mortgage rates; indirectly, inflation and the state of the economy.

The purpose of the following is to help you make a more informed and better decision in selecting a mortgage. Interest rate is only one of many components to consider when selecting a specific mortgage program and this page is meant to help understand rate, outside of other factors to be considered, such as financial goals and lifestyle needs, when selecting a mortgage loan.

A better understanding of the economy helps make better investment mortgage decisions, i.e. whether to use an adjustable rate mortgage or a fixed rate mortgage, and interest only mortgage or a fully amortizing mortgage, purchase an item with a credit card or pay cash, to purchase or not to purchase real estate.

Additionally, familiarity with economic statistics also helps in gauging the extent of media hype vs. reality.

First, we need to start with some back ground information on mortgages. The rate you pay for your mortgage is analogous to the rate of return an investor receives upon buying a mortgage backed security.

Mortgage Rates, Bonds, & Inflation

A group of mortgages bundled and securitized, know as mortgage backed securities, creates a bond. And bonds do not like inflation.

Say you lent $1,000 to a friend who paid you back the full $1,000 20 years later and during that time prices of things you buy increased by 3% each year. The $1,000 you receive 20 years later would only buy $550 worth of stuff at today’s prices. That’s like lending $1,000 and getting back $550 20 years later.

If you charged your friend 3% per year of interest on the loan, the amount you received at the end of 20 years would have the same purchasing power as the original $1,000. Say you lent the money at 3% to account for inflation, and as time passed inflation increased to 4% or 5% or more, you’d be losing money. This is why bonds hate inflation. The interest rate is fixed on a bond at the time of purchase, so inflation erodes the purchasing power of the money a bond investor receives.

Because of this Bond prices adjust according to inflation. If inflation rises bond prices increase to account for higher inflation, which means interest rates on mortgages go up as well.

This is why watching inflation and economic factors that affect inflation becomes so important to understanding the mortgage interest rate environment.

US Economy

To understand how and why interest rates move, it’s important to look at the economy as a whole. Although mortgage rates may vary from state to state, county to county, and city to city, national economic trends affect mortgage rates in the same way across the nation.

It only takes understanding and tracking three economic measurements to get a fairly clear picture of the current economic environment. These are…

• Gross Domestic Product (GDP)
• The labor market
• Inflation

Look to the right side of this page to see real time stats and read on for a brief explanation of each stat.

Gross Domestic Product – Is the economy speeding up, producing more goods and services? Or, slowing down, producing less goods and services? The answer lies in GDP trends.

GDP is the measure of all goods and services produced and sold in the United States and exported from the United States. The Bureau of Economic Analysis (BEA) reports quarterly GDP numbers monthly as Advance, Preliminary, and Final for a given quarter. Click here for the Q3 2007 GDP report.

The Jobs Report – Bureau of Labor Statistics publishes the jobs report on the first Friday of every month for the previous month. This is one of the most highly anticipated reports of the month. There are many components to the jobs report, but looking at two components—the unemployment rate and non-farm payroll change (a.k.a. job creation) numbers—provides a fair gauge of the current labor market environment. Most economists agree that unemployment under 5% is healthy and that creation of 150,000 new jobs per month will sustain 3% GDP growth without upward pressure on inflation.

Go to the chart on the right, click on Non-Farm Payroll-Chg and click the 3Yr view of the graph and you’ll see, albeit choppy, a downward trend in job creation since Jan-06.

Inflation – Ever hear or read one new report that states inflation is 3.5% and one day later hear another report stating inflation is 1.9%? The chart on the right shows 5 different measures of inflation reported by the Bureau of Economic Analysis. There are many other inflation measure, but these 5 illustrate the overall inflation environment.  The following FAQ defines each of these measures.

• What is Core inflation? – Core inflation is simply inflation without food and energy costs included in the number.
• What is PCE? – Personal Consumption Expenditure (PCE) is the measure of change of the prices of products consumers are buying right now.
• What is CPI and how is it different from PCE? – Consumer Price Index (CPI) is the measure of change of prices of a fixed basket of goods. Meaning, the products measured in the CPI number never change whether consumers are buying those goods or not. Where as, the PCE number, measures what consumers are buying.
• What is PPI? – Producer Price Index (PPI) is the measure to price change in goods raw materials purchased by manufactures. This number is important to watch because an increase in PPI means producers are paying more for raw materials and may pass those cost increases onto consumers, causing CPI and PCE to rise.

The Federal Open Market Committee is also very concerned with maintaining a favorable inflation environment and wants to keep core inflation between 1 and 2%. 

Why?  Here are a few reasons.

1. Bonds don’t like inflation and mortgage rates are directly tied to bonds. If inflation rises, mortgage rates follow--discussed at the top of this page.
2. At 5% inflation, in 50 years a $5 latte would cost $57!
3. At 3% inflation, a person retiring on a fixed income at age 60 would loose 55% of their purchasing power by age 80.

Productivity – Productivity is important to watch because an increase means it takes less time and resources to produce an item than it took to produce the item before the increase. A decrease in productivity increases the time and more effort to produce an item, costing more to produce the item. This is inflationary.