Mortgage Rates on the Rise

Money costs right now way more then it used to even three months ago. The nationwide average of mortgage rates rose to 6. 71 percent, whereas only a week before it was 6. 63 percent. This is the highest level for 30 year mortgages since May 31, 2002, when they averaged 6. 76 percent (McLean, V. June 22, 2006). According to Bankrates. com weekly national survey, the current mortgage rates rose on average 12 basis points and the rate on a 30 year fixed loan is approaching 7 percent (Lewis, H. June 29, 2006).

The results of such a rise in mortgage rates will be dramatic for national housing sector. While it was powered for the last five years with the lowest mortgage rates the country ever seen, home sales in May 2006 fell 6. 6% compared with May of 2005. While there can be a number of reasons for a rise in mortgage rates, economists blame inflation fears as the major factor. Unstable energy prices can well result in self-feeding inflationary psychology of a general consumer. There is a general downturn in personal savings, economic growth rates, and income growth rates.

While at the present moment consumers rely heavily on savings and increase own spending, economic analysts suggest that situation will be reversed in the future, being largely a determinant of higher energy prices. Even though Federal Reserve is trying to ease up inflation fears relying on an increase in consumer spending in May, the relief is expected to be temporary, as consumers simply will not be able to keep up with inflation using personal savings (CNN, June 30, 2006). Mortgage rates, being a factor of expected inflation rates, also rise.

Since mortgage rates constitute the major costs of owning a property, they drive the demand for real estate in the market. The rate itself has three basic components: the real riskless rate, the risk premiums and inflation rate. While the real riskless rate refers to the rate on governmental securities and risk premiums to the financial reward on an investment for holding not risk free securities, the two factors are relatively stable. As such, mortgage rate becomes a factor of expected inflation rates.

The relationship between the two is direct, as in case if there would be a significant inflation, the value of money invested right now would be lower since it would be worth less in the future. As such, relationship between mortgage rates and inflation fears is, basically, a positive correlation. This idea is also supported by the historical data on US expected inflation and mortgage rates. As it is evident from the graph, the difference between the two factors throughout the period from 1965 and up until 2000 remained around 5%. Around 1980, mortgage rates

were almost equal to expected inflation rates, however, in the next two years there was a significant rise in mortgage rates. As such, the reason for low difference between the two factors can be attributed to the failure of economists to objectively predict the expected inflation rates. In 1980, Federal Government switched to the policy of controlling money supply and setting the target supply zones. While the policy was effective for economic growth, however, the lack of regulation in 1980s resulted in high inflation rates that have been coupled with high interest rates.

As such, the expected inflation rate could not have been objectively predicted, which resulted in virtually equal mortgage and expected inflation rates. To define the concepts, inflation refers to a continuous raise in prices of goods and services produced in an economy. When it comes to speaking about short term causes of inflation, they can be grouped into two classes: those resulting from changes in supply and those resulting from a change in demand. In the long run inflation is caused by the growth of national money supply that is accompanied by a lower growth of national product.

Demand pull inflation occurs when supply for goods and services is higher then the ability and desire of consumers to purchase those. The excess demand results in an increase in prices of both goods and services, but as economy adjusts over the long term, prices fall as a larger number of goods and services is supplied into the market. However, when it comes to speaking about the expected inflation in United States for the upcoming years, the type of inflation is the cost push one. Cost push inflation occurs when the production costs rise including possible imposed taxation, and, consequently, they must be passed on by producers to consumers.

United States economy is experiencing a rise in the cost of materials – energy prices are rising. According to Martin Crutsinger (June 6, 2006), import prices are rising at twice the rate expected alongside with the costs of petroleum and industrial supplies. The United States foreign oil bill climbed to $23. 8 billion, a jump in oil prices per barrel resulted in an all-time high of $75. 17. Another issue is related to prices on autos and auto parts imported from China. The United States deficit with China raised to $17 billion, which not much below the highest rate faced in October - $20 billion.

Even though the trade deficit is falling, it is still high for an average performance of economy. As such, the current increase is mortgage rates can be attributed to the cost push inflation resulting from a rise in prices of exported materials and energy prices. The possible outcome of the current inflation can be a wage price spiral. This is one of the worst forms of inflation, when higher wages result in higher prices and an increase in expected inflation rates leads to an increase in wages. A famous economist Irvin Fisher suggested a one to one relationship between mortgage rates and expected inflation rates (Hull, J, and White, A.

1993). As such, in case if expected inflation rate rises by 1 percent, a mortgage rates will also increase by 1 percent. This trend is described in the graph above that presents the long term data on the two variables. When mortgage lenders loan money, they experience a number of other risks aside from inflation. Even though the risks are multiple and complex, they remain relatively constant and still mortgage rates remain to be a factor of expected inflation rates. Interest rate is one of constitutes of mortgage rate and normally it occurs because of fluctuations in the market.

As interest rate rises, the value of mortgage loans falls. While variable mortgage loans can be a subject to adjustment, the adjustment is not immediate and cannot be applied to fixed rate mortgage loans. Credit risk is another factor that influences mortgage rates and refers to inability of a borrower to pay out the loan principal. The general trend of default rate is to increase, but it still remains to be relatively low due to the nature of the industry. Maturity risk is related to the loan term. The longer the term of the loan, the greater is the maturity risk as a result of uncertainties associated with the investment.

As a result, mortgage rates are higher on longer investment projects. Finally, mortgage lenders are also exposed to prepayment risk, as the law allows homeowners prepayment of principal without any penalty. As prepayment shortens the term of the loan, it also exposes lenders to the risk of reinvestment, as new opportunities must be found for reinvestment. When interest rates fall investors normally are able to pay off mortgages through refinancing and, consequently, lenders have to refinance the money at a lower rate.

It should be further noted, that inflation is directly related to the stated above risks that are included into major factors influencing mortgage rates, For instance, credit or default risk occurs when homeowners are not able to pay out the loan. The likelihood of the default increase with higher inflation rates especially when it comes to speaking about cost pull inflation. As home owners have to spend more money on regular products, less funds is available to pay out the mortgage and, consequently, the likelihood of default increases.

Inflation also influences regular other interest rates, which, in their turn, contribute to higher mortgage rates. The relationship between mortgage loans and expected inflation rates is direct. Even though mortgage rates are influenced b other factors such as default risk, prepayment and maturity risk, they remain relatively constant, most importantly, are also influenced by the level of inflation especially in cases when it is caused by lower rates of supply. As such, they key determinant of mortgage rates is expected inflation and the relationship between the two is 1 to 1.

As such, the current increase in United States mortgage rates can be attributed to higher expected inflation rates. Inflation, in its turn, is the supply push type and is caused by an increase in energy prices. Even though at the present moment consumers spend more, economy is growing at a lower rate then the average and for this reason economic analysts expect higher inflation rates in the future.

References

  • Crutsinger, M. June 9, 2006. Import Prices Rise More than Expected, Raising Interest-Rate Fears. Associated Press. Retrieved July 5, 2006, from http://www.bankrate.com/mortgage.aspx?type=refinance&market=4&propertyvalue=362500&loan=290000&perc=20&prods=215,393,216,392&fico=740&points=Zero&cs=0