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Over the last month you have seen the news about the Federal reserve cutting the interest rates. Every time this happens I get hundreds of calls, from old clients of mine, wondering what the rates are at? What they don't understand is that the news media is getting this completely wrong. Many people and news experts have a misunderstanding about the change in the federal funds rate and how it affects mortgage rates. Not understanding this can cost you a lot of money on a 30 year mortgage. You need to have an understanding that the Federal Reserve does not determine mortgage rates.
Let me explain how mortgage rates are determined. Basically, when you take out a mortgage, the bank or mortgage company is making you a loan at a given interest rate. Sometimes the firm that makes the loan holds onto it, like a local bank. But more often than not, the lender or mortgage company sells that loan to an institution that packages it with other mortgages into what's known as a mortgage-backed security and then sells that security to investors. That investor, whether it's a mutual fund or a large institutional investor, earns a return by collecting the principal and interest payments that you and all the other mortgage borrowers make. To get those investors to buy the mortgage-backed securities, they must pay a competitive interest rate compared to investments like a treasury bond. The average loan lasts for about ten years so an investor compares the mortgage-backed security to a 10-year Treasury note. Of course we are not as good a risk as the government so rates on mortgages are going to run about 1.7% higher than the 10-year treasuries. Now this investment is competitive in the market and people will invest in it.
The next factor that can really affect rates is inflation. Lets say you are going to invest into one of these securities and planned to hold onto it for ten years. Inflation in the next ten years could dilute the actual value of payments received from these securities. As a general example you are at 6% on your security but inflation is growing at 3%, your "real" interest rate return is only 3%. Therefore if inflation is expected to go up so will interest rates. The other side of the coin is if inflation is expected to go down then rates should follow suite.
These are the two main factors in determining mortgage rates but other factors are involved. Too many factors to be explained in such a small article. The bottom line people want to know when are rates going to drop so I can refinance? "Unfortunately, there's no tool for predicting the future path of rates. Doing so would require that you be able to take into account the myriad factors that determine rates -- the health of the economy, the outlook for inflation, the flow of investors' money between stocks, bonds, mortgage-backed securities and other investments -- and translate all those factors into an accurate prediction for rates." said expert Walter Updegrave, Money Magazine. I agree, the only thing you can do is stay on top of your broker or bank and lock that
