Let’s talk about inflation and mortgage rates. Inflation is the single biggest factor in interest rates. The higher inflation goes, the higher interest rates will go. Why is this?
Who sets mortgage interest rates?
It’s helpful to know that your lender is not lending their own money when they give you a mortgage. Rather, they make your mortgage, and then sell it for a profit to an investor (usually Fannie Mae or Freddie Mac.) Fannie / Freddie then borrows money from Wall Street hedge funds or institutional investors who want to invest in your mortgage.
In other words, the decision-maker who determines what yield they need to earn on their investment is the one who ultimately provides the funds that enable lenders to make your mortgage. So why is inflation important in this equation? This is easiest way to understand by using a personal example.
My Fantasy Example
Let’s say I want to buy a sailboat today. Here’s a nice example of a Catalina Morgan 442 that I could buy for $200,000. I can pay cash. (Actually, I can’t, but this is a really nice fantasy, so indulge me.) But just as I am about to make an offer, my best friend asks if he can borrow $200,000 for five years. He’ll pay me back in total exactly 5 years from now. I calculate that means he’ll pay me back $250,000. (I didn’t bother compounding the interest for all you math nerds.*) That sounds like I could still get the boat and have money left over, right?
However, if inflation is running at 5%, then in five years the boat will now cost me $250,000. All I’ve done is defer buying the boat of my dreams for five years. The point is, investors know that they must earn more than inflation, or they are earning nothing at all.
Inflation and Mortgage Rates
Institutional investors (think insurance companies, pension funds) are no different than me when it comes to investing. (Well, except they have a lot more money. I mean, a LOT more money.) They need to beat inflation or they are losing purchasing power.
When they buy mortgage-backed securities (the instrument by which they lend money to Fannie Mae or Freddie Mac) they need to earn enough to cover inflation for the likely duration of the mortgage pool.
Inflation Does Not Drive Mortgage Rates Directly
There is one more element, however. The Consumer Price Index (CPI) is a backward-looking measurement of the cost of a very specific basket of goods. Investors base their needs, however, on future inflation, which of course they can’t measure. What they can do is project what inflation might be, based on current inflation, economic trends, and whether or not the Government (via the Federal Reserve) is taking moves to limit inflation moving forward.
In other words, it’s not exactly correct to say that mortgage rates depend on inflation. It’s more correct to say that mortgage rates depend on the expectation of future inflation on the part of institutional investors.
The bottom line: if inflation runs out of control, expect higher mortgage interest rates.
Casey Fleming, Author The Loan Guide: How to Get the Best Possible Mortgage (On Amazon)
Mortgage Advisor, Fairway Independent Mortgage / NMLS 344375
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My Blog: www.loanguide.com
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This article represents the opinions of Casey Fleming, and not necessarily those of Fairway Independent Mortgage Corp. This analysis was prepared with the best information available at the time it was written. Neither Casey Fleming, nor Fairway Independent Mortgage Corp., have any magical insider information about bond markets, real estate markets or mortgage markets that would make economic projections any more reliable than any other source. No warranty is made that the outcome will reflect the projections in this article, and neither Casey Fleming nor Fairway Independent Mortgage Corp. are responsible for decisions that you make regarding your own choices about your real estate or mortgage or those of your clients.
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- $250,000 compounded at 5% interest for five years = $255,256.31 (For the math nerds)