What determines mortgage interest rates?

Often consumers harbor several misconceptions about factors that determine mortgage rates. One of the major misconceptions is that the Federal Funds Rate fixed by Federal Reserve impacts the mortgage rates. However, it surprises consumers when the Federal Funds Rate is cut by the Fed and the mortgage rates don’t go down. This is because mortgage rates or mortgage interest rates are determined by MBS or Mortgage Backed Securities.

Trading of the Mortgage Backed Securities takes place every business day similar to bonds and stocks. Mortgage rates are determined by the demand for the mortgage backed securities. This is because, increasing demand (for MBS) causes price of MBS to escalate thereby lowering the yield which in turn pushes the mortgage rates low.

The thumb rule is that an increase in investor demand for mortgages lowers the mortgage rates. This can be understood by a simple example.

If you have invested in stocks and one fine day you withdraw your cash from stocks to invest in a safer investment vehicle which you find in MBS. MBS are comparatively safer although they are “fixed income investments”. So, if the demand of stocks drops, the demand for Mortgage Backed Securities could escalate.

There is one more factor that can determine mortgage rates. It is inflation. Low inflation can also help demand for mortgages to go up. Mortgage backed securities and bonds are usually fixed income investments so inflation will reduce the returns from fixed income investments. However, if inflation is low and if you have invested in fixed income investment vehicles, your investments remain attractive.

On the contrary, if inflation is high, these fixed income investments become less attractive for consumers thereby increasing the mortgage interest rates. So, why do mortgage rates increase when Fed decreases rates? This is because lower Federal rates acts as a stimulus and causes inflation to go up in near future. This is however not very good for the mortgage bonds. As such mortgage rates go up when the Fed cuts its rate.