Unraveling the Mortgage Rate Mystery

Mortgage rates don't appear out of nowhere; get the inside line on how rates are set before you start shopping for a new or refinanced mortgage.

Famous psychic Elizabeth Baron might be able to tell you what mortgage rates will be tomorrow or next week; but then again, she might not. Since psychic powers can be fickle, a little bit of research on your part might be a more reliable way to unravel the mortgage rate mystery.

Fannie, Freddie, and the Fed

Fannie Mae and Freddie Mac are quasi-government agencies that pump money into the mortgage industry. They do this by purchasing and guaranteeing mortgage loans, and then repackaging those loans into securities that are sold to investors. While you don't need to understand the nuances of mortgage-backed securities (MBS), you do need to keep an eye on what's happening with Fannie and Freddie. The success of their operations is subject to the interests of investors-the folks who are buying the MBS. When investors' collective interest in these securities trails off, as has happened recently, the money flow tightens and mortgage rates face upward pressure.

In theory, this system is self-balancing. As mortgage rates rise, investor interest is revived by the opportunity for greater returns. In reality, the activities of Fannie, Freddie, and their investors are not the only factors influencing mortgage rates. That's why even the experts aren't able to predict future rate trends consistently.

The actions of the Federal Reserve Bank's Federal Open Market Committee (FOMC) fall into the category of other influencing factors. The FOMC regulates the country's money supply by:

• Buying and selling government securities
• Setting the federal funds rate, which drives short-term lending rates

Both of these actions affect mortgage rates indirectly. While it might seem that a reduction in the federal funds rate would lead to an equivalent decrease in mortgage rates, that's not always the case. This action could, in fact, lead to an increase in mortgage rates, if the lending community disagrees with the FOMC's strategy. If the FOMC cuts rates sharply, for example, long-term mortgage rates could rise based on the fear of inflation. Lenders and investors lose interest in low-rate 30-year mortgages if they believe inflation could rear its ugly head in the short term.

Keeping tabs

To understand where rates are going, you could stay on top of various economic trends and make your best assumptions, or you could watch pricing on MBS. They reflect investor interest, which is essentially a collective opinion based on all available public information. When investor interest is falling, MBS prices go down. This, in turn, puts upward pressure on rates. The reverse is also true; when MBS prices go up, rates often go down. Unfortunately, MBS pricing information isn't readily available to the public. You'll have to defer to a well-informed lender-who should be a far better resource than psychic Elizabeth Baron.