How Are Interest Rates Determined?

More than 2 out of 3 of us are directly affected by mortgage interest rates. We own our homes and we owe mortgages on our homes. Those of us who rent are affected as well, because we are renting someone else’s home and their mortgage rate may impact our rent. And then, many of us may want to purchase a home or we may choose to refinance or get an equity line on our home.

Who Sets the Rates?
The process goes like this:

• Investors sell mortgage commitments on the New York Stock Exchange in the “bond market”.
• Mortgage companies buy these commitments and promise to deliver the closed loans.
• The interest rates are set in this buying and selling process.

After a mortgage is closed it is packaged and sold to investors in large “pools” of other loans through the New York Stock Exchange. These “mortgage backed securities” are bought and sold in the bond market just like stocks. Just as stock prices constantly change when the stock market is open, bond prices change as well. Investors are reading the economy, the Federal Reserve decisions, political factors and other influences around the world to determine the interest rate and points they are willing to offer for lending the mortgage funds.

Up or Down?
What causes these bond traders to price their mortgages up or down? The Economy! That’s right. As the economy picks up speed and grows too fast, the Federal Reserve increases the Fed Discount Rate. The bond traders are reading the economic signs much quicker than The Federal Reserve because they are trading every day. The Feds meet about every 45 days. So the interest rates usually change before the Feds have announced their decision to raise the discount. The Feds have increased the rates 16 times in the last 23 months as they read the economy. This causes people and businesses to borrow less, delay purchases, or defer an expansion of their company. These decisions slow the economy down (which is happening very slowly as you read this.)

Why slow down the economy (my wife just asked!)? Because, if it grows too fast or too much it WILL crash. Not good. Like 1929.

And the opposite happens as well. As the economy slows down slowly, the Federal Reserve will bring the Discount Rate back down . . slowly. And that will cause people and businesses to begin their purchasing again . . . slowly.

Yes, the rates will be coming down . . . slowly as a result. We call this a “soft landing”. This is good. As the economy slows . . . gradually, the rates will come down . . . gradually. Be patient. The Federal Reserve is doing a good job achieving a stable economy.

Footnote: The Feds may need to raise the discount another one or two times to achieve their goal of slowing down our economy. Again, be patient. It’s working.

Peter M. Galde is the founder and principal at Cornerstone Capital Funding, 14500 Mono Way, Suite 110, Sonora Ca. 95370. Peter has 28 years experience in the finance industry. E mail Peter or call him on 209 532 7711 for further information.