What causes mortgage rates to fluctuate

·Yahoo! Homes Contributor

Like everything else, mortgage interest rates fluctuate based on supply, demand and inflation. But it's not just how many loans borrowers want that matters – interest rates are perhaps most affected by what's happening in the secondary mortgage market.

The secondary mortgage market is where loans and servicing rights are sold by market leaders Fannie Mae and Freddie Mac and bought by investors such as mutual fund companies, banks, hedge funds, and teacher and municipal pension funds.

Short-term loans. One- to five-year adjustable-rate mortgages (ARMs) and other short-term loans generally track the Federal Reserve's Federal Funds interest rate. In some instances, ARMs are tied to the London Interbank Offered Rate (LIBOR), London's Fed Funds equivalent. (In that case, it's called the LIBOR rate, not the Fed Funds rate, and it directly affects interest rates in Europe as well as in the U.S.)

The Fed Funds rate and LIBOR are the interest rates that banks charge each other to lend money overnight, and they influence whether short-term rates go up or down.

Banks are required by regulators to keep a minimum level of liquidity, otherwise known as cash on hand. The higher the Fed Funds rate is, the more it costs for banks to borrow the cash needed to satisfy this requirement. If banks are paying more in interest, they'll avoid borrowing by hanging onto what they have on hand and making fewer loans. And when they do lend money to consumers, it's at higher interest rates.

In a difficult economic environment like the one we're facing today, the Fed lowers the Fed Funds rate in hopes of spurring economic growth. This lower rate makes it more affordable for banks to borrow funds, and they don't feel the need to keep all their cash to themselves. Or, at least that's the economic theory in play today.

A low Fed Funds rate generally means banks are more willing to lend, and they do so at lower rates because they're spending less to borrow the money. ARM rates are lower as a result, so borrowers pay less and thus have more money to put back into the economy.

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On Wednesday, the Fed announced it would keep interest rates at below 0.25 percent in an effort to further stimulate the housing market and, hopefully, the broader economy. The Fed plans to keep interest rates near zero until the unemployment rate drops to 6.5 percent, as long as inflation remains in check.

The unemployment rate was 7.8 percent in December, and economists predict it will be nearly unchanged when January numbers are released.

Long-term loans. While short-term interest rates generally track the Fed Funds rate closely, long-term loans like 15- and 30-year fixed-rate mortgages (FRMs) tend to track the interest rate of Treasury notes and bonds. These instruments are issued by the U.S. government with maturities that range from five to 30 years.

Rates for these long-term U.S. securities fluctuate daily as they're sold at auction to investors. If there is a high demand for the notes and bonds, the interest rates will drop as investors' returns (yields) fall. Since they're paying more for the securities, they're making less money.

The opposite is true when demand for Treasury notes and bonds is low. Investors are paying less to purchase them, which means their yields are higher, and that generally means interest rates follow suit.

The Fed recently promised it would continue to purchase $45 billion in Treasury bonds per month, following through on an initiative it began in September 2012. This process, commonly known as "quantitative easing," is an effort by the Fed to put more money into the market and increase lending and liquidity. In addition, the Fed is reinvesting other monies it receives (like dividends and loans that are paid off), to the tune of another $35 to $40 billion per month, for a total of $80 to $85 billion in monthly quantitative easing.

This move has met with mixed reviews, as some experts believe it could lead to problems in the future.

Esther L. George, president of the Kansas City Fed, voted against the continued quantitative easing when the Federal Open Market Committee announced it Wednesday. She cited concerns that the continued high level of "monetary accommodation" increased the risks of future economic and financial imbalances and, over time, could cause an increase in long-term inflation.

Currently, the Fed has nearly $3 trillion on its balance sheet. That number was around $500 billion before the start of the recession.

The impact of mortgage-backed securities

Since the housing bubble burst, the Fed has gotten more involved in the secondary mortgage market in an effort to encourage economic growth. It recently promised to purchase billions of dollars' worth of mortgage-backed securities until the job market improves, hoping to encourage investors to borrow and spend more money.

The move means lower yields – and therefore, lower interest rates – because the Fed is taking most mortgage backed securities off the market. If investors want to own and hold mortgage backed securities, they have to compete for them with the Fed.

"This shows that the mortgage-backed securities are a safe investment for large pools of money from institutional investors," says Joe Caltabiano, senior vice president at Guaranteed Rate. "The more money that goes into the buying of bonds, the less they need to pay in yields [to investors] on those bonds, thus driving the price of bonds lower."

Knowing that mortgage-backed securities are a safe investment will help keep interest low and stable for all borrowers.

Ilyce Glink is an award-winning, nationally syndicated real estate columnist, blogger and radio talk show host, and managing editor of the Equifax Finance Blog. Follow her on Twitter @Glink.