Mortgage Rate Conundrum

As many of you have already heard mortgage rates spiked substantially this week, and for an economy made up like ours this is not good. The reason why this is bad is because the mortgage lending arm of a every bank in the country essentially froze. The reason for this is quite simple, the number of people who could afford or desired to take out a loan at 4.25%, can not or will not take one out at 5.5%. This means all those escrow signs need to be taken down and its back to square one for the sellers. Almost all the loans that were in the pipelines are going to be dead. Weeks or months worth of work for brokers, worthless.

This goes to show that home prices across the country are still much too high. Home prices only seem affordable because rates are so low. Lets say you are trying to get a loan for $100,000 and the rate is 4.25%, this puts your monthly bill at $491.94. Now if rates go up to 5.5%, your payment is now $567.79. That's a 14% increase we saw happen in one day this week. The days of 4.25% rates are gone, they are not coming back, and most likely only going up from here. What happens when rates go up to 8.00%, which is the more in line with historical norms, your payment would be $733.76 or 35% higher. This means that house prices would have to drop this much just to keep the current pool of buyers in the game. This is why I always say it is better to buy at a good price then a good interest rate. A good price will provide greater flexibility when the time comes to sell. This is the reason you see so many defaults right now, and should expect to see more as rates go higher.

Why can't we keep rates at 4.25%? Well the Fed is sure trying their best to do just that. The problem is no one can control the rates, it is up to the forces of the market to determine what the rates should be. So, even though many people think the Fed has this power, they do not. Which brings us to our next topic. What the hell was the Fed thinking?

Mortgage rates are based off the interest rates on the 10 year Treasury note. Back in March of this year the Fed introduced a plan to try and control the interest rates of 10T notes. This plan, called 'Quantitative Easing', is quite simple. The Fed would flood the market(print money) with 10T notes to try and drive down the interest rates on these notes. The thinking goes, if there is a crap load of any one thing it becomes really cheap(air, water). Well, the problem here is that two things determine an interest rate, the risk of default, and inflation. Let's discuss both of these issues.

First, the problem of risk. If I were to loan someone $1000 dollars that was in severe debt. I would absolutely charge a high interest rate because I fear that person may never pay me back. Which is essentially what we have with the US government. People may not know this, but when people buy 10T notes, they are essentially loaning money to the US government. Now the US government is in extreme debt, so it would only make sense to charge a higher interest rate to make that loan to the government.

Now, the issue with inflation. Printing money buy itself does not cause inflation to rise. The money actually has to circulate for that to happen. But it does put that much more money in the system that will be available eventually. It is this point that is also driving up interest rates on 10T notes. Currently, a 10T note will pay you, say, 2% interest for 10 years. Now, if I know that by year 3,4,5 of my 10 year note that inflation is going take off with a vengeance due to all the printing, then I better offset any chance of loss due to inflation by charging a higher interest rate now.

So you can see why the Fed has absolutely no control over the rate of interest on its 10 year notes. The market, and only the market decides what the rate should be. It calls all bets. You can also probably guess where interest rates are going in the future. They will never be at 4.25% again, not with the current policies in place. This is a dangerous game the Fed is playing, and it looks like they lost.

Stay sexy.