The Complex World of Fed Rates and Mortgage Rates (Rielly Quoted)

The complex world of fed rates and mortgage rates.

Starting last September, the Federal Reserve Board began aggressively lowering interest rates. Yet, lately, mortgage rates have been on the increase: February ended with the highest 30-year rate in more than three months.

Confused? So are many other consumers.

A mortgage-backed security is a type of bond representing an investment in mortgage loans, explains Greg Rielly, founder of Private Mortgage Banking of Washington and a certified mortgage planner at Mortgage Advisory Group in Everett, Wash. To comprehend the movement of mortgage rates, one needs to understand the bond market and how this relates to the way mortgages are financed.

When a financial institution lends money for a mortgage, it rarely keeps the loan on its books. Instead, the mortgage lender usually sells the loan on the secondary market, securitizing it. Conventional mortgages are securitized through the Federal National Mortgage Association, better known as Fannie Mae, and the Federal Home Loan Mortgage Corp., commonly known as Freddie Mac. Both Fannie Mae and Freddie Mac are shareholder-owned corporations that exist to provide an ongoing source of capital to mortgage lenders. They pool groups of mortgages into bond investments called mortgage-backed securities and guarantee timely payment of principal and interest to investors.

In the bond market, there is an inverse relationship between bond prices and yields. When bond values increase, bond yields decrease. Conversely, when bond values decrease, yields increase.

Why is this so? Consider what would happen if an investor owned a bond with a face value of $10,000 on which he received 3 percent annual interest, and later, comparable bonds were paying investors 5 percent. If the investor wanted to sell his lower-yielding bond, he would have to accept a price less than $10,000. How much less would be determined not just by the rate but also by the amount of time until the bond matures.

The state of the economy, the perceived risk of inflation, and stock market performance are all factors that affect bond values and yields.

According to Sharpe, in a weak economy, bond yields generally come down, causing mortgage rates to be lower.

If investors are worried about inflation, however, that makes the U.S. dollar worth less, and the result can be a sell-off in bonds. Bond yields will rise relative to the corresponding lower values. Consequently, mortgage rates will follow bond yields and also be higher.

Lately, higher inflation has created some turmoil in the bond markets, pushing mortgage rates higher.

According to Rielly, the relationship between the stock and bond markets plays out as a battle for investment dollars.

In a rising market, Rielly says, investors will move their money to stocks for the greatest rate of return. When bond dollars are lost to the stock market, bonds typically are worth less, and interest rates rise.

"On the other hand, in a deteriorating market, a low tide, investors don't want to be caught skinny dipping," Rielly says. They will likely change course and quickly transport their money to more secure investment instruments like bonds, he says. In this case, bond values typically will increase, and rates will be lower.

If the Fed continues cutting rates, certain mortgage and home equity borrowers will benefit. According to Sharpe, variable-rate loans such as home equity lines of credit and many adjustable rate mortgages are tied to short-term interest rates, which generally follow movement in the Federal Funds Rate.

Doreen Fox Kelsey is a freelance writer and consumer advocate who lives in Spokane.

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