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Mortgage rates moved dramatically all through the COVID-19 pandemic. Mortgage rates first plunged to record lows in the early phase of the health crisis. However, during the recovery period, they not only reached the pre-pandemic levels but also kept rising.
Why have mortgage rates actually moved so dramatically and what is it that drives movements in mortgage rates? The answers to these questions might be complex, but the moves make much more sense after you learn more about the factors that drive mortgage rates and those that don’t.
The following is a quick crash course that may very well end up saving you money on a new mortgage or refinance.
1. The Federal Reserve Is Where Everything Starts
The Federal Reserve is not responsible for setting the mortgage rates, but the decisions that the central bank makes have a real influence on the mortgage rates.
As the United States economy was being hammered by the COVID-19 pandemic back in 2020, the U.S. Federal Reserve stated that it was planning to keep interest rates near zero for the foreseeable future.
The immediate consequences of the decision by the Federal Reserve in 2020 was an immediate plunge in the mortgage rates. Similarly, as the U.S. Federal Reserve started to hike interest rates in 2022, mortgage rates also rose in anticipation of those moves from the central bank.
The interest rate decisions by the Federal Reserve tend to drive shorter-term products such as home equity lines of credit and credit cards. On the other hand, mortgage rates typically move based on the longer-term interest rates.
It is actually the longer-term outlook for both inflation and economic growth that have the greatest bearing on the level and direction of mortgage rates. Since mortgages are typically packaged into securities and subsequently sold as mortgage bonds, it is the return that investors demand that determines the general level of mortgages.
Mortgage rates are priced above that of the 10-year U.S. treasury, regarded by investors as essentially a risk-free investment. The spread in pricing between the 10-year treasury and mortgage rates reflects the risk borne by investors that hold those bonds.
The fact that 30-year mortgage rates are typically priced relative to 10-year treasury bond yields might seem counterintuitive, but once the 3-year mortgages have been packaged together into bonds, they typically tend to pay out over a 10-year period as homeowners move, refinance, or otherwise repay their loans early.
2. Economic Conditions Also Matter
Mortgage pricing is also affected by what happens in the economy and how those events affect investor confidence. Both bad and good economic news have an inverse impact on the direction of mortgage rates.
Bad economic news is usually good news to mortgage rates. If the concern about the economy is high, investors tend to be attracted to significantly lower-risk investments such as mortgage bonds and Treasury bonds, which push bond prices higher but the yields on the bonds lower.
Good economic news, such as robust GDP growth, increase in consumer spending and confidence, and a bullish stock market usually tend to push mortgage rates higher. The reason for this is that higher demand translates to more work for lenders that have only so much manpower to originate the loans and money to lend. The effect was on full display back in late 2021 and early 2022 when mortgage rates spiked with strong job growth and the economy in recovery.
3. The Impact of Inflation Shouldn’t Be Ignored
Inflation refers to the increase in the prices of goods and services over time. It is an important benchmark used to measure economic growth. If inflation rises, it limits the purchasing power of consumers, which is a consideration made by lenders when setting mortgage rates.
Lenders must adjust mortgage rates to a level that compensates for eroded purchasing power if there’s a sudden rise in inflation. After all, lenders must still make a profit on the loans that they originate, which can become harder if the buying power of consumers is diminished.
Inflation is also an important consideration that investors make in the prices they are willing to pay and the returns they demand, on mortgages as well as other bonds purchased on the secondary market.
Inflation held at low levels for decades, but the trillions of dollars issued in federal stimulus programs in 2020 resulted in sharp price increments in 2021 and 2022. Inflation spiked to its higher level in 4 decades, hitting about 7.9% in February 2022, which leads to the first item on this list- soaring prices.
4. Your Financial and Credit Picture
The first 3 items above all have to do with the economy at large. This factor, however, focuses on you and your creditworthiness.
Lenders want to be confident in your ability to repay your mortgage and to do that they assess your risk of default. The most crucial indicator of your ability to not only manage debt but also pay bills on time is your credit score. If you have a lower credit score, you can generally expect to pay higher interest rates and your loan options will be more limited if you have less than stellar credit.
Lenders also pay close attention to your debt-to-income or DTI ratio. The DTI ratio is the sum of all your monthly debts, which includes the new monthly mortgage payment, in relation to your gross income each month.
The higher your DTI ratio, the riskier the lender considers you to be and the higher your interest is likely to be. Conventional lenders will generally want to see your DTI ratio remain below 43%, but some loan programs consider borrowers whose DTI ratio is as high as 50%.
Your DTI ratio will fall as mortgage rates fall since a lower rate will translate to lower mortgage payments each month, which is included in your DTI ratio calculation. So, you can essentially afford to buy more houses.
5. Origination Costs
The final item on this list doesn’t have anything to do about the economy or borrower but rather about the lenders’ bottom lines. Mortgage origination costs include tasks such as underwriting, running a credit check, a title search, and numerous other steps the lender takes when processing a loan.
Tighter lending regulations that were introduced following the 2008 housing market crash have cut into the profits of lenders since they have changed their systems to comply with the new regulations. That has pushed the cost of originating mortgages higher.
In Q4 of 2021, the mortgage origination cost rose to $9,470 per loan, which was up from Q3’s $9,140 per loan, according to the Mortgage Bankers Association. That’s a steep increase from the average costs of $6,758 per loan that lenders averaged from 2008 through 2021.
When setting the prices, lenders first look at the origination costs and then set their desired margins above those costs. The more efficient a mortgage manufacturer can be, the more competitive they can be on pricing.
If there’s a surge in the demand for mortgages, lenders may need to account for the spike along with the processing costs involved by hiking the prices of their mortgages. Similarly, when the demand is either flat or it drops, lenders must adjust their prices to attract more business.
Mortgage Rates Are Always A Moving Target
They can change weekly, daily, or hourly, and can be difficult to time perfectly. If you are considering a home purchase or mortgage refinance, you should compare mortgage rates offered by multiple lenders and find out the ideal time when to lock in your loan.