(This article is the first of a three-part series on understanding different types of mortgage interest rates.)
To understand interest rates in long-term fixed rate loans, the first thing to do is tune out the media noise around the Fed and the Prime Rate.
Long-term mortgage interest rates are based on the bond market -- specifically, how the bond market is trading the U.S. 10-year Treasury bonds. In short, when the price for bonds goes up, long-term interest rates go down (or, to put it in terms that you'll understand by the end of this article, long-term mortgage rates move up and down with yields on the 10-year Treasury.)
A bond is a promise to pay, basically; the 10-year Treasury bond is a financing tool used by the U.S. Government with which it borrows money from investors and promises to repay them over a 10 year period at a certain, fixed interest rate. Since their interest rate is fixed, those fixed rate promises to pay become more valuable or less valuable based on how things are going in the economy.
Let's look at an example -- how the bond market would change its opinion on the US Government's promise to pay 5.5% on its 10-year bond in response to a government news release showing strong job growth. Good news on job growth is a positive sign for our economy; with more people employed, more money will be available for spending on goods and services -- all else being equal, investment returns should increase (meaning that an investor can make more money with his investment funds.)
In this light, the U.S. Government's promise to pay 5.5% is not as exciting as it was before the good economic news came out.
(Time for some bond market jargon: Bonds are priced per $1,000. If I buy a bond for $1,000, I am buying it at "par" (at face value, you could say -- the price at which nobody is making any money.) If I buy it for $950, I am buying it at "discount"; if I buy it at $1,050, I am buying it at a "premium.")
Back to our example, then, I would be less likely to pay $1,000 for a unit of the 10-year priced at 5.5%; I might think that $960 is a price that better reflects the value of that 5.5% income stream based on how I feel about today's economy.
(More bond market jargon: the "current yield" of a bond is what you get when you divide the amount of income a bond will pay by its current price.)
So if I'm willing to pay $990 for the 5.5% 10-year Treasury, its yield would be $55/$960 = 5.73%.
Back to our example, if before the good jobs data came out I was willing to pay $995 for the 5.5% 10-year, the current yield would have been 5.53%.
That means that the impact on mortgage rates of this good piece of jobs data would be increasing rates by (5.73% - 5.53%) = 0.20%, or just less than a quarter of a point.
In short: good economic news made interest rates increase. Conversely, bad economic news makes bond traders willing to pay more for the 10-year Treasury, which makes yields (and long term mortgage interest rates) decrease.
Next in our series: Understanding mortgage rates: Adjustable rate loans
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