How Are Mortgage Interest Rates Set?
Mortgage rates are set through the daily interaction of key economic factors and not one particular bank or government agency. These factors reflect the changing conditions in the economy and affect how lenders perceive the risks and gains from making mortgage loans. Similarly, prospective homeowners time the purchase of a home to take advantage of lower interest rates to help minimize the cost of home ownership.
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Inflation
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Inflation is the increase in the prices of goods and services throughout the economy. One of the causes of inflation is accelerated economic growth that increases the demand for money circulating in the economy. These periods of fast growth are characterized by larger incomes, increased spending, lending and borrowing levels. Since the supply of money in the economy is fixed, until adjusted by the Federal Reserve, the higher demand pushes the level of interest rates upward nationwide.
Monetary Policy
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To control the effects of inflation on economic development, the Federal Reserve makes monetary policy decisions to promote steady, long-term growth. Although the Federal Reserve is not authorized to directly set any market interest rate, the agency has the authority to indirectly influence interest rates by adjusting the federal funds rate. The federal funds rate is the short-term interest rate banks charge each other for short-term loans. The federal funds rate is part of the cost banks incur to obtain funds to cover reserve requirements or meet other investment obligations. If the cost of obtaining funds increases, the increase is passed onto borrowers to keep profit levels steady. The opposite is true when the federal funds rate is decreased.
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Housing Market
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The housing market is largely defined by changes in the supply and demand for homes. More home buyers drive up interest rates if the supply of new homes is unable to keep up with demand. However, the opposite is true if there are more homes available than mortgage borrowers. This drives down mortgage rates to make buying a home more attractive to prospective homeowners.
Expectations
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Expectations about future conditions in the mortgage market impact present and short-term mortgage interest rates. Lenders pay attention to developments in the economy, government policy and housing market. Lenders examine the possible impact of these developments on mortgages. For example, if lenders expect inflation to increase in the coming years, lenders adjust present interest rates upward to keep up with the effects of inflation on returns.
10-Year Treasury Bond
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The 10-year Treasury bond is a government bond issued by the U.S. Department of the Treasury. Treasury bonds are a common way to fund government spending, especially in cases where deficit spending is required to keep federal programs operational. The mortgage market considers the 10-year Treasury bond an indicator of long-term interest rates. Since most mortgages are long-term repayment arrangements, mortgage lenders can price current mortgages to help keep the mortgages profitable in the coming years.
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