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Getting a handle on mortgage rates
How are mortgage interest rates determined, and how do I figure out where mortgage rates are headed?
October 16, 2003: 12:47 PM EDT
By Walter Updegrave, Money Magazine

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NEW YORK (CNN/Money) - How are mortgage interest rates determined, and what indicators can I watch to better understand where mortgage rates are headed?

-- Awilda Marquez, Honolulu, Hawaii

Put the first part of your question -- What or who determines mortgage rates? -- to a couple dozen people and I think you'd quickly come up with a list of usual suspects: it's the banks, or the mortgage brokers, or the big mortgage packagers like Fannie Mae or Freddie Mac or maybe even Alan Greenspan and the Federal Reserve. And each of those answers is partly, but not exactly right.

In fact, it's all those things, and many more, including you, me and everyone else in the market for a mortgage or looking to invest money, who ultimately set mortgage rates.

I know that may sound kind of vague and loosey-goosey, maybe even nonsensical, so let me explain.

Mortgage rate basics

Basically, when you take out a mortgage, a bank, mortgage company or other mortgage originator is making you a loan at given interest rate. Sometimes the firm that makes the loan holds onto it.

But more often than not, the lender or mortgage originator 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.

Mortgage demand drops
Mortgage rate update
Bonds and rates

In order to get investors to buy those mortgage-backed securities, they must pay rates of interest that are competitive with alternative interest-paying investments such as Treasury bonds.

You might figure that, since a 30-year mortgage has the same term as a 30-year Treasury bond, mortgage rates might track the rates on long-term Treasury securities. In fact, 30-year mortgages remain outstanding on average about 10 to 12 years, so rates on 30-year mortgages tend to track the yields on 10-year Treasury notes.

Of course, since you and other mortgage borrowers aren't as good a credit risk as Uncle Sam, rates on mortgages are somewhat higher than those on 10-year Treasuries. In general, 30-year mortgage rates are about two percentage points higher, but that spread can vary depending on the supply and demand for Treasuries and mortgage-backed securities as well as a number of other factors.

Don't forget inflation

One other crucial element that helps determine mortgage rates is the outlook for inflation. If investors believe prices are likely to rise significantly in the future -- that is, inflation is on the rise -- then interest rates will rise as well.

The reason is that inflation dilutes the future value of the fixed interest payments the investors will receive. So investors will demand protection in the form of higher interest payments, which means higher rates for borrowers.

On the other hand, if investors believe inflation will head down in the future, they're willing to accept lower rates.

I've given you only a quick overview here. For a fuller discussion of the various factors that go into mortgage rates, I suggest you check out the explanation on the HSH Web site.

Where are rates headed?

As to the issue of figuring out where rates are headed, that's a dicier proposition. Professional investors who specialize in bonds would love to be able to know in advance which way interest rates are headed.

If they knew, for example, that rates were about to drop sharply -- a move that would boost the value of existing bonds since bond prices move in the exact opposite direction of interest rates -- managers would load up with bonds, particularly long-term bonds, and then reap the gains as bond prices rose. If they believed rates were about to jump, they'd dump their bonds in order to avoid losses.

But interest rates, like stock price movements, are one of those things that are easy to gauge when looking backwards and extremely difficult to predict looking ahead. The same goes for mortgage rates. You can easily track the history of rates on all sorts of mortgages over the past five years by going to the interactive graphs available at the Web site.

Unfortunately, there's no similar 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.

Most professional investors aren't able to do that, so I doubt that most individuals are up to it either. I know I'm not.

You may, however, be able to get a general sense of whether inflation is on the rise or falling -- and thus whether rates are likely to head up or down in the near future -- by following the news on the consumer price index.

And if you really enjoy crunching numbers, you could try looking at the trend in the spread between the rates of 10-year Treasury notes and 10-year Treasury Inflation Protected Securities or TIPS. (You obtain this spread by subtracting the yield for 10-year TIPS from the yield on 10-year Treasuries.)

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When the difference between the two is rising, that generally means investors expect rising inflation. But I certainly wouldn't advise you or anyone else to try to time your decision to borrow based on these or any other indicators.

Of course, I also recommend that you follow the ups and downs of mortgage rates -- and, indeed, there have been lots of ups and downs this year -- by checking out CNN/Money's regular coverage of the mortgage markets.

And you can always get the latest rates being offered in your area for various types of mortgages by going to our RateSearch section.

Walter Updegrave is a senior editor at MONEY Magazine and is the author of "Investing for the Financially Challenged." He also answers viewers' questions on CNNfn's Money & Markets at 4:40 PM on Monday afternoons.  Top of page

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