What Home Buyers Need To Know

Other Forces Help Determine Whether Buyers Pay More Or Less For A Mortgage

Every six weeks or so the financial market is dominated by discussion of whether the Fed will “raise rates” or “cut rates.” What does that mean for the interest rate on my mortgage?

How The Fed Affects Interest Rates

“The Fed” refers to two bodies that come together to set interest rate policy:

• The first is the Federal Reserve Board (also called the Board of Governors of the Federal Reserve System), which is based in Washington, D.C, composed ordinarily of seven members called Governors, and led by Chairman Jerome Powell.
• The second is a network of 12 regional Federal Reserve Banks, each headed by a President.

The Federal Open Market Committee (FOMC), which officially sets interest rate policy, has up to 12 voting members: all members of the Board of Governors plus five of the 12 regional Bank Presidents. The President of the New York Fed is always a voting member of the FOMC, while the Presidents of the other 11 regional Banks rotate each year. The non-voting regional Bank Presidents participate in the FOMC meetings and discussions, but don’t have votes. “The Fed” often refers specifically to the FOMC.

The FOMC holds two-day meetings about every six weeks on a schedule announced well in advance. The members have a dual mandate established by Congress: “maximum employment” and “stable prices.” Interest rate policy is the FOMC’s tool to advance that pair of goals, but they may conflict with each other. In a “hot” economy employment may be near its maximum but inflation is likely to be raging, while in a “cold” economy prices may be stable but employment may be well below its maximum. After one meeting each quarter the FOMC publishes a “Summary of Economic Projections” (called “Projection Materials” on the web site) designed to show the interpretation of current and likely economic conditions of meeting participants—voting and non-voting—without identifying them by name.

Because the goals of the dual mandate may conflict, the FOMC tries to achieve a balance between them. When the economy is too hot, the FOMC raises interest rates, which causes businesses to reduce their investments and individuals to reduce their consumption, in turn helping to combat inflation. Conversely, when the economy is cold, the FOMC reduces interest rates, encouraging more investment and consumption and helping to boost employment. At the end of each meeting, the FOMC publishes a statement outlining any action it decided to take and revealing how voting members voted, and the Chair holds a press conference to discuss the current economic situation. Three weeks later the Fed also publishes the minutes of the meeting, giving greater detail on the discussions held before the final vote.

The FOMC doesn’t directly set most interest rates, including mortgage rates. Instead, the FOMC establishes a “target range” for a specific interest rate, called the Federal Funds Rate. The actual rate is set by transactions among banks for overnight access to funds that they hold in accounts at Federal Reserve Banks, but the Fed engages in transactions in the open market designed to nudge the Fed Funds Rate into the target range. That’s enough to affect a whole range of other interest rates, including mortgage rates.

How Does The Fed Affect Mortgage Rates?

The interest rate on any loan comes from an agreement between a borrower and a lender. The borrower wants to borrow money; the lender has a certain amount of money available to lend out, and also wants to be compensated for the risk of lending it. Because of that dynamic, any interest rate reflects the balance between demand and supply for loans, and also reflects all of the perceived risks in making that loan. The Fed can affect all of those drivers: loan demand, loan supply, and various risks.

In the housing market, the main factors affecting mortgage interest rates include the following:

Inflation Risk

For any loan with a fixed interest rate, inflation transfers money from the lender to the borrower even though it does not affect the interest paid. To see this, imagine you have a fixed-rate mortgage with a monthly payment of $800. Every time you make that mortgage payment, it prevents you from buying something else with that money—say, 10 concert tickets that cost $80 each. If high inflation drives the price of concert tickets to $100, then making the mortgage payment requires you give up the money equivalent of only eight concert tickets, so you are better off. On the other side, the lender had originally expected to get enough money to buy 10 concert tickets, but instead got money worth the equivalent of only eight.

Because high inflation makes the borrower better off but the lender worse off, when inflation is high—or when higher inflation is expected—the lender will not be willing to make the mortgage loan unless the interest rate is higher by enough to compensate for the loss in the lender’s purchasing power. On the other side, the borrower will be willing to pay the higher interest rate if they expect the higher inflation to erode the purchasing power of the payments they have to make. So higher inflation and higher expected inflation both translate into higher mortgage rates.

Household Economic Conditions

Interest rates as a whole tend to be higher when general macroeconomic conditions are stronger, and lower when the macroeconomy is soft. This happens for three reasons:

• First, as noted before, the FOMC will generally adjust interest rates to keep the economy growing moderately, enabling it to achieve its dual mandate.
• Second, when the macroeconomy is “hot” there is more demand for borrowed money among both businesses (for investment) and individuals (for consumption), which tends to drive interest rates up. Conversely, when the economy is “cool” there is less demand for borrowed money, which tends to drive interest rates down.
• Third, when the economy is “hot” both lenders and borrowers expect higher inflation, which makes lenders less willing to lend unless the interest rate is higher and makes borrowers more willing to pay the higher interest rates.

On top of this, however, when economic conditions are especially strong for households, mortgage interest rates tend to be a little bit higher because the strong household economic conditions make households willing to pay a little bit more for various goods, including homes. So some measures of a healthy economy that are especially relevant to households—such as average hourly earnings and average weekly overtime hours—are associated with slightly higher mortgage interest rates.

The Strength Of The Housing Market

As with any other good, when there is more demand for housing the cost tends to increase. That is true both for house prices themselves and for interest rates on the mortgages that enable people to buy houses. When increased demand for housing drives an increase in the number of housing units started, or under construction, such an increase in construction activity is typically associated with higher mortgage interest rates. Similarly, faster house price increases—also driven by higher demand—are also associated with higher mortgage interest rates.

Term Risk

Another risk is simply that conditions will change before the loan is due for repayment. For example, the U.S. Treasury borrows money from investors by issuing Treasury securities that will come due for repayment after various amounts of time such as 30 days, two years, or 10 years. Short-term loans are called Treasury bills or T-bills, medium-term loans are called Treasury notes, and longer-term loans are called Treasury bonds. The interest rate on such securities is set in open-market transactions, but ordinarily it is higher on longer-dated bonds and lower on shorter-dated bills, and the increment is called the “term spread.” That gives rise to what is called the “term structure of interest rates,” which can be depicted in a curve showing the market interest rates (yields) on Treasury securities with different maturities.

As an aside, sometimes the term structure slopes downward and is called an “inverted yield curve” or an “inverted term spread.” This may happen because investors are concerned that the economy will enter a recession soon—and, if that happens, they believe that the FOMC will reduce policy interest rates. If you think that is what will happen to interest rates, and you want to invest in bonds that will pay off in, say, five years, it may be better to make a series of investments in shorter-term bonds at today’s higher interest rates rather than locking in the five-year investment at the lower interest rates that other investors expect will come later.

As with any other debt instrument, the interest rate on a U.S. Treasury security is set by transactions in the open market, and therefore is the rate at which the aggregate supply of securities of that type exactly equals the aggregate demand among investors for securities of that type.

The most common mortgage has a 30-year maturity, but most mortgages don’t last that long. Many borrowers prepay their mortgages before the 30-year maturity date in one of three ways: by coming up with the cash to retire the mortgage, or by selling their homes (at which time the mortgage gets paid off), or by refinancing the original mortgage. Those factors mean that 30-year mortgages have an actual average maturity much closer to 10 years (or even seven). For that reason, there is a strong relationship between mortgage interest rates and the yields (market interest rates) on 10-year bonds: when 10-year bond yields increase or decline, mortgage interest rates tend to increase or decline by about the same amount.

Another Tool The Fed Uses to Affect Mortgage Rates: Quantitative Easing And Operation Twist

For most of the time since 2007, in addition to its Federal Funds Rate target, the FOMC has also used another tool specifically to affect longer-term interest rates, especially mortgage rates. In the open market, the Fed can buy or sell the same sorts of securities that individual investors can buy or sell, including U.S. Treasury bonds and mortgage-backed securities. In response to the 2008-09 financial crisis the Fed started a program of “Quantitative Easing” under which it bought longer-dated bonds, especially mortgage-backed securities, and in 2011 the Fed modified it with what became known as “Operation Twist” under which it continued to buy longer-dated bonds while selling shorter-dated bonds that it already held. The goal of both programs (and of a second version of Quantitative Easing that became known as “QE2”) was specifically to help the housing market by pushing down mortgage interest rates, while also encouraging business investment by pushing down the interest rates on the longer-dated bonds that businesses often use to fund them. In other words, the Fed can take actions specifically to counteract an upward-sloping yield curve, or to cause or exaggerate an inverted yield curve, in order to help stimulate more demand for housing by holding down mortgage interest rates.

Credit Risk

The U.S. federal government is considered the strongest credit risk in the world, meaning that there is very little chance that it will default on any of its borrowing—in fact, the interest rate on the shortest-term T-bills is often called the “risk-free interest rate.” Any lender, including banks and investors, implicitly compares the risk of default on a given debt to the risk that the U.S. federal government would default on a debt with the same maturity. Because credit risk is basically always higher for other borrowers than for the U.S. Treasury, other borrowers can expect to pay a higher interest rate, with the increment called the “credit spread.”

(That is why it is so important for Congress to raise the statutory debt limit: if the federal government’s borrowing needs ever exceeded the debt limit, then the U.S. Treasury would be forced to default on some of its borrowing; the U.S. would then have to pay higher interest rates forever because it would no longer be considered the “risk-free” borrower.)

Corporations, state and municipal governments, and other large borrowers typically ask a credit rating agency to rate the risk of default on any bond that they consider issuing, to help investors gauge the interest rate at which they should be willing to lend money by investing in those bonds. Because a lower credit rating means a higher default risk, the yields on lower-rated bonds are generally higher than the yields on higher-rated bonds to compensate investors for the additional credit risk, and the incremental yield is called the “credit spread.”

Mortgage borrowers don’t have the same deep pockets as large corporate borrowers, but that doesn’t mean mortgage borrowers are necessarily more likely to default. The amount initially lent in a mortgage is typically no more than 80 percent of the property’s value, or else the borrower is required to purchase mortgage insurance to compensate the lender if the homebuyer defaults. Because of that, the credit risk on a mortgage is typically approximately equal to the credit risk on a corporate bond that would be given a medium credit rating (such as a Baa rating by Moody’s, one of the leading credit rating agencies). That means that the interest rate on a 30-year mortgage is generally within a couple of percentage points of the market yield on medium-rated corporate bonds.

Why Is My Mortgage Rate Higher Than Someone Else’s?

This discussion has all been about what affects mortgage interest rates in general. Of course, nobody pays a mortgage interest rate in general—so what determines why one borrower’s mortgage interest rate is higher or lower than another’s?

Credit Risk Again

As noted, in general the credit risk for mortgages is not all that different from the credit risk for medium-quality corporate bonds. But there is wide variation in credit risk among mortgage borrowers, just as there is wide variation in credit risk among corporate borrowers. The difference in interest rates paid by the highest-risk and the lowest-risk corporate borrowers can be more than 15 percentage points. Mortgage interest rates don’t generally show quite that much spread between borrowers with higher and lower credit risk, mostly because companies with very high risk of default still have an incentive to pay high interest rates because the only alternative may be bankruptcy—whereas households have a very good alternative to paying such high mortgage interest rates, namely choosing to rent their home instead of buying it.

Fixed-Rate vs. Adjustable Mortgages

The interest rate on a fixed-rate mortgage stays just that: fixed over the entire duration of the mortgage. Adjustable-rate mortgages, ARMs, come with a wide variety of provisions, but all of them share one thing in common: when interest rates increase (or decline) in general, the interest rate on each ARM is likely to increase (or decline) sooner or later—the only questions are when and by how much.

Whether the mortgage interest rate is fixed or adjustable determines whether the lender or the borrower is more exposed to the risk of changes in market interest rates. If market interest rates increase but you borrowed under a fixed-rate mortgage, the increase in market interest rates does not affect you. It hurts the lender, though, for two reasons. First, the lender no longer has the money that they lent to you, and therefore they cannot make a loan to another borrower at the new, higher market interest rate. Second, most lenders are also borrowers—they may, for example, pay interest on deposit accounts specifically so they can use the deposited money to make loans—so an increase in market interest rates makes it costlier for them to borrow, but if you have a fixed-rate mortgage then they can’t pass that higher cost along to you.

The opposite holds if you borrowed under an adjustable-rate mortgage: if market interest rates increase, then that hurts you but not the lender. That imbalance means that the mortgage interest rate is usually lower—to start—with an adjustable-rate mortgage. With a fixed-rate mortgage the initial interest rate has to be high enough to compensate the lender for the risk that market interest rates will increase, whereas with an adjustable-rate mortgage the initial interest rate can be relatively low because the lender expects to get more interest later when market rates go up.

30-Year vs. 15-Year Mortgages

Most mortgages in the U.S. run for either 30 or 15 years, and the interest rate on a 30-year mortgage is typically higher than the interest rate on a 15-year mortgage, for two reasons. The first reason has to do with the term risk noted above. Remember that term risk is the risk that conditions will change before the mortgage matures—which is higher, of course, if there is more time for things to change before the mortgage matures.

The second reason has to do with credit risk. Every time you make a mortgage payment, part of that payment reduces the amount you owe on the mortgage, which is called the remaining principal amount. The principal payment is higher on a 15-year mortgage, so the remaining principal amount goes down faster. Most homebuyers who are having trouble making their mortgage payment will not default if the house is worth more than the remaining principal amount—instead they will sell the house, which makes it possible for them to pocket the difference between the property value and the remaining principal amount. (That difference is called their equity in the house.) So, if the remaining principal amount goes down faster, then the likelihood that the borrower will default on the mortgage also goes down faster. That means the credit risk also goes down faster, so the lender is willing to make the mortgage at a lower interest rate.

Even though a 30-year mortgage generally has a lower mortgage interest rate than a 15-year mortgage, most borrowers choose a 30-year mortgage because the monthly mortgage payment is typically quite a bit higher for a 15-year mortgage.

Timing And Competition

The last factors that affect a particular borrower’s mortgage interest rate are when they locked in their rate and how much competition there was among lenders to make that particular loan. Every lender will be paying daily attention to the factors that affect the general level of mortgage interest rates—the level of the Federal Funds Rate, term risk, overall credit risk, inflation risk, the strength of the housing market, etc.—and also to the credit risk for that particular borrower (as they estimate it with the help of the borrower’s credit report). But lenders are also in competition with each other, so on any given day the borrower may be offered loans from different lenders with very slightly different mortgage interest rates. A lender who has asked for quotes from multiple lenders may be able to find one offering the mortgage they want with a slightly better rate compared with the rate they might have gotten if they asked for a quote from only one lender.

So How Will the Fed’s Announcement Affect Me?

Every time the Fed meets, its decision on interest rate policy may affect you in several ways—but, even if is likely to affect you, that does not mean that you should worry about it.

I Earn Money From Working

The most important thing to keep in mind is that the Fed’s interest rate policy is designed to achieve its dual goals, “maximum employment” and “stable prices.” If the Fed increases interest rates, then the reason is almost always because the FOMC members expect macroeconomic conditions to strengthen—and, in that case, even if mortgage interest rates increase, it is likely that your own household economic situation will benefit in some way too. Conversely, if the Fed reduces interest rates, then the reason is almost always because the FOMC members expect macroeconomic conditions to weaken—and, in that case, even if your own household economic situation weakens too, you may benefit from lower interest rates and/or lower prices.

I Have An Adjustable-Rate Mortgage

If you already purchased a house using an adjustable-rate mortgage, then any decision the Fed makes to raise or lower the Federal Funds Rate target will likely affect your mortgage interest rate, too—not necessarily right away, but according to the rate-adjustment terms of your mortgage. If there is a Fed meeting coming up, then you can look at something like the CME FedWatch Tool to make a guess as to whether the Fed Funds Rate target is likely to increase, decline, or stay that same. Based on that guess, you can prepare your own financial situation so that you’ll be able to make a mortgage payment that is slightly higher, slightly lower, or about the same as your current payment.

While you’re at it, you may want to use the CME FedWatch Tool to make a guess as to what will happen to interest rates farther into the future, too. For example, as this article is being written, the market expectation is that the Fed Funds Rate target will be higher at its next meeting than it is now by 1/4 percentage point, but that by a year from now it will be lower than it is now by a full percentage point.

I’m Thinking About Buying A House

The Fed’s interest rate policy should NOT be an important consideration in whether you buy or rent your house, nor in which house you buy. There is exactly one good reason to buy a house: because that is the house you want to live in, and you can’t live in it unless you buy it, and you can afford to buy it while also paying your other expenses. If any part of that is “no,” then you may want to think again before buying.

If you have already decided to buy a particular house, though, paying attention to the Fed may help you decide when to lock in the interest rate on your mortgage, and also whether you should agree to a fixed-rate or an adjustable-rate mortgage. Again, take a look at the CME FedWatch Tool. If, for example, it suggests that the Fed is likely to raise the Fed Funds Rate target at its next meeting, then you may want to lock in your mortgage rate before that rate increase happens. And if, as now, the tool suggests that the Fed Funds Rate target is likely to be lower in a year or so than it is now, then you may feel comfortable about taking on the risk of an adjustable-rate mortgage.

There is one thing that you really need to keep in mind, though, if you are going to try to strategize in this way: the lenders are all looking at the same information, and they have much more practice at it than you do. For example, if the CME FedWatch Tool leads you to guess that the Fed is likely to raise the Fed Funds Rate target at its next meeting, then the lenders are probably making the same guess—and the mortgage rate they are offering you today reflects that information. And if the CME FedWatch Tool leads you to guess that the target rate will be lower in a year or so than it is now, then the lenders are probably making the same guess—and the difference in interest rates on an adjustable-rate versus a fixed-rate mortgage reflects that information, too.

The first job I took after I finished my Ph.D. was as an economist at the Federal Reserve Board, focusing on the mortgage market. At the same time, my wife and I had found a house that we could live in if we bought it, and we had determined that we could afford to buy it. I asked my colleagues—also Ph.D. economists at the Federal Reserve Board focusing on the mortgage market—whether they thought I should lock in my mortgage rate or wait in case I might get a lower rate in the future. Every single one of them told me the same thing—“I don’t know”—because it simply isn’t realistic to try to outsmart the capital market. So I really, really don’t think you should worry about the Fed’s interest rate policy in making your own mortgage decisions.