Consumers looking for a home loan, or who want to refinance an existing mortgage, need to know that mortgage rates may rise as inflation increases. Understanding the difference between the inflation rate and interest rates — and how they interact — is key for anyone shopping for a mortgage.
Does inflation affect mortgage rates?
While inflation doesn’t directly impact mortgage rates, the two tend to move in the same direction. Rising inflation can shrink purchasing power as prices of goods and services increase. Higher prices can then influence the Federal Reserve’s interest rate policy, affecting the cost of borrowing for lending products like mortgages.
First, let’s discuss inflation
What is inflation?
Inflation is a loss of purchasing power (or rise in prices) over time, meaning your dollar will not go as far tomorrow as it did today. It is typically expressed as the annual change in prices for everyday goods and services such as food, furniture, apparel, transportation and toys.
What causes inflation?
It can be the result of rising consumer demand. But inflation can also rise and fall based on developments that have little to do with economic conditions, such as limited oil production and supply chain problems.
Is inflation bad?
Not necessarily, it depends on the circumstances. Rapid price increases can be troublesome, but moderate price gains can lead to higher wages and job growth.
Can inflation affect the stock market?
Rapidly increasing inflation usually spells trouble for stocks. Financial assets in general have historically fared badly during inflation booms, while tangible assets like houses have held their value better.
How does inflation affect the poor?
Inflation can be a burden for poor households because they spend a larger part of their budgets on necessities like food, housing, and gas.
Supply and demand
When demand for “safer” debt securities (bonds and mortgages) increases, the supply decreases, so prices increase, and the yield (your return) decreases. Since the mortgage market is closely tied to bond yields, this drives mortgage rates down.
Conversely, when demand for “safer” debt securities decreases, the supply increases, so prices decrease, and the yield increases. Again, since the mortgage market is closely tied to bond yields, this drives mortgage rates up.
Mortgage rates and bond rates
Most mortgages are packaged and sold to investors as mortgage-backed securities (MBS). The money generated by these sales is channeled back to lenders and used to fund more home loans. These securities behave just like bonds — They provide the investor with a recurring stream of interest and principal payments. In short, mortgage rates tend to move in the same direction as bond rates.
The yield earned by investors is driven by the mortgage rate that’s charged to homeowners. Essentially, mortgage-backed securities are an alternative for investors who want to earn fixed income. However, in order for them to be appealing to investors, the yields must be competitive with other types of bonds.
Inflation influences bond rates
When inflation is high, the income earned by bond investors has less value, because its purchasing power has been reduced. Therefore, fixed-rate bonds tend to be less attractive to investors during periods of high inflation.
As noted above, a decline in bond demand creates a decline in bond prices. Bond yield is a function of the price and the stated interest rate on the bond; thus, a decline in its price leads to an increase in its yield.
Both mortgage-backed security yields and mortgage interest rates tend to move with bond yields. Since inflation rates impact bond yields, they also impact mortgage rates. Or, as consumer prices get higher, so do mortgage interest rates.