When it comes to interest rates in relation to your credit card, student loan or home mortgage, you probably know the interest rate is the price you’re paying to borrow money. But when you hear about interest rates in the headlines, what kind of rates are they talking about? And if rates are moving up, what does this mean for your mortgage or other lines of credit?
The answer isn’t simple.
First, let’s talk about interest rates. An interest rate is simply the cost of borrowing money. Recently, headlines have been focused on the fact that interest rates are moving higher after a prolonged period of decline. As an example, the 10 year U.S. treasury yield (another term for interest rate) hit a low near 1.35% in July of 2016. The recent rise leaves the yield near 2.9%, which is an increase of 1.55%, a fairly significant one when it comes to rates.
The rate you hear referenced in the news is what’s called the federal funds rate, or the rate banks charge one another for short-term loans. You might think this has little relevance to you but when the Federal Reserve (“Fed”) sets the rate, it is essentially sending a signal about the state of the economy. In addition, other interest rates tend to move in a similar direction as the fed funds rate. Think of the Federal Reserve as a dam operator in which its decision to move the fed funds rate up, down or not at all can either inhibit, encourage or maintain the status quo when it comes to economic activity.
For example, when economic activity is high, rates might be low, causing more people to want to borrow money because they are confident they’ll be able to pay it back. If rates move higher, people might stop wanting to spend and borrow money, thus slowing down overall economic activity.
So let’s circle back to the 10 year U.S. treasury rates and look at the factors that cause them to move:
- Expectations about what the Federal Reserve will do with monetary policy, otherwise known as the fed funds rate. Changes in this rate flow through into bank lending rates and into longer-term rates to some extent.
- Supply and demand also have an impact on interest rates. For instance, the supply of U.S. treasuries increases along with deficit spending (government spending in excess of revenue) and a resulting increase in the national debt. On the flip side, the Federal Reserve can increase the demand for government debt instruments. This is what happened after the financial crisis when it began to make regular purchases of government bonds, allowing for fewer to be available in the market (this is called quantitative easing). The Fed is now reversing that demand by allowing these bonds to “roll off” their balance sheet as they mature.
- Inflation expectations can significantly affect longer-term interest rates, such as the 10 year treasury rate. When you buy a U.S. treasury, you’re lending money to the U.S. government. If you expect inflation to rise, you would require a higher interest rate on the money you are lending to compensate you for the rising costs of goods and services.
Now that you know a bit more about what moves interest rates, let’s talk about how these changes in U.S. treasury rates can impact mortgage rates, or the rate you pay to finance the purchase of a home. As 10 year treasury yields rise, so do mortgage rates. Why? Great question.
Although most mortgages are sold in 30 year terms, the average mortgage is paid off or refinanced within 10 years. Mortgages are pooled together to form what are called mortgage-backed securities, which are then sold to investors. Mortgage rates, however, will be higher than treasury rates because investors who purchase these mortgage-backed securities need to be compensated for taking on additional credit risk. Unlike U.S. treasuries where the U.S. government is guaranteed to pay back its debt, there is no guarantee that people will pay their mortgages, making it possible for the mortgage-backed security to lose value.
The difference between the 10 year U.S. treasury rate and mortgage rates is called the “spread” and it changes all the time. What’s more, the spread may be different depending on your personal profile. Generally speaking, advertised rates will assume that you have a credit score above 760, you are making a 20% down payment on your purchase, and that the property will be an owner-occupied single-family home. Rates will be higher for those with lower credit scores, in cases where the down payment amount is less than 20% and/or if the property is a second home (all of these factors increase credit risk).
Obtaining the lowest possible interest rate is an important factor in determining whether a property will be affordable for you. A small difference in your mortgage rate can be the difference of thousands of dollars in your annual payment, so you can see why a move up in interest rates can have a negative impact on the housing market in general.
We’ve experienced a long period of abnormally low rates allowing homeowners to lock in low rates for new home purchases or refinancing of existing mortgages. As rates move higher, the decision to buy a new home might become more difficult thanks to higher monthly payments, even though the total loan amount is the same.
This is just one reason why interest rates and related mortgage rates can have an impact on economic activity. As you can see, it’s a complicated subject but the news about the Federal Reserve’s decision to move rates does affect you and economic activity as a whole.