As consumers we are all aware of the role interest rates play in our lives. Whether you have student loans, a credit card, or a mortgage, interest rates are part of the mix. They are the price paid for borrowing money, either as an individual consumer or as a bank. Understanding how interest rates work is very important before borrowing money. Rates rise and fall based on three broad driving factors: the economic state, inflation, and investor supply and demand.
Understanding why interest rates are constantly on the move can help you make smart decisions about your money, like when to buy or refinance a home, take on new debt, or invest. Let’s take a closer look at each driving force behind interest rate movement.
The state of the economy both in the United States and abroad has an impact on mortgage interest rates. When economic activity is strong – such as low unemployment, a strong Gross Domestic Product (GDP), and a positive outlook on the future – interest rates have a tendency to rise. This is because consumers are spending their hard-earned money which in turn increases demand for big-ticket items, like a home purchase. When demand is high, but supply is low, interest rates go up.
The opposite is also true. When the economy looks bleak, consumers are less willing to spend their money. In the housing market, home sales may decrease when economic activity slows, which leads to lower demand on mortgage lenders, but a higher supply across the board. To entice buying, mortgage rates drop.
Inflation also plays a role in the rise and fall of interest rates. You can think of inflation as the purchasing power of your money. Each year, your dollars are able to purchase less because the cost of goods increases over time. As inflation rises, so do interest rates. Because a large portion of mortgages are offered as fixed-rate loans stretching over 15 or 30 years, lenders want to know the money they receive in the form of monthly repayments from borrowers has a built-in inflation hedge. When inflation is on the rise, mortgage interest rates increase to protect lenders from losing out on purchasing power in the future.
When inflation is stagnant or negative, mortgage interest rates tend to decline. There is less of a risk of losing purchasing power, and interest rates reflect this lowered risk.
Another driving force behind interest rate movement is investor activity, specifically in the bond market. Bonds and mortgage-back securities compete for the same investors – those who are looking for relatively stable, fixed rates of return on their investments. Both treasury bonds and mortgage-backed securities offer this, although bonds have less risk than mortgage investments. When interest rates rise on treasury securities, mortgage securities investors will demand higher rates on their investments to help offset the risk of investing. That leads to an increase in interest rates passed on to mortgage borrowers.
When treasury bond interest rates decline, so do mortgage-backed securities rates. The mortgage rates offered to borrowers are also lower when this takes place.
While these factors are important to understand as a consumer, whether you are buying a home or refinancing a mortgage, it is also necessary to recognize the interest rate associated with your specific mortgage needs to be compared to your APR.
The annual percentage rate is reflected as a percentage, just like the interest rate, but it also includes fees paid for borrowing. Each lender is different in terms of the fees assessed for taking out a new mortgage, and the APR reflects this more clearly than the interest rate alone. As interest rates rise, APRs are also likely to increase, and the same is true when interest rates fall. It is essential to take a close look at your APR on a mortgage loan to help determine the total cost you pay for borrowing to buy or refinance a house.
The movement of interest rates can be complex, given the number of factors that drive increases or decreases in the market. The best step you can take to ensure your home loan is affordable is not to keep a pulse on interest rate fluctuations but instead focus on your creditworthiness as a borrower. Regardless of where interest rates stand when you plan to purchase or refinance a home, you need to be in good financial standing to qualify. Put your energy toward creating the best possible financial picture of yourself for your lender and you’ll be in great shape for your next mortgage, no matter where interest rates are headed.