Why are mortgage interest rates still so low? According to conventional wisdom, interest rates were supposed to begin creeping up in April, right after the Fed quit buying mortgage-backed securities. Instead, they've lower than ever.

So what gives? And when will they start rising again?

Basically, interest rates are low because investors are nervous. And when investors are nervous, they look for safe investments - and are willing to accept lower-than-normal returns.

What's making them nervous? The Greek financial crisis, for one thing, which threatens to destabilize the Euro. A still sputtering U.S. economy. A potential conflict between North and South Korea, which could put a big dent in production of automobiles and consumer electronics. Big fluctuations in the stock market. Even the eruption of the volcano in Iceland played a role, by putting a crimp in air travel and freight hauling.

What's considered a safe investment? Treasury securities, which are backed by the full faith and credit of the U.S. government, are the big one. When things look shaky, that's where investors turn.

Demand for Treasuries affects mortgage rates

Because they play such a dominant role, the interest rate paid on Treasury securities tends to influence interest rates in general, including those on mortgages. Here's how.

When demand for U.S. Treasury securities goes up, investors are willing to pay more for them. Paying more means a lower return on their money - effectively, lowering the interest they pay out.

For example, if you pay $100 for a security that pays a return of $5 a year, you're earning 5 percent interest. Pay $125 for that same security with the same $5 return, you're only earning 4 percent. This is basically why the yield - or interest paid - on Treasury securities goes down when the price goes up, and vice versa, although it's a bit more complicated in practice.

Mortgages as an investment

So what does this have to do with mortgage rates?

For investors, mortgages are a type of investment. Individual mortgages taken out by borrowers are bundled into mortgage securities that investors purchase. The investor effectively becomes the one who is loaning the money to the borrower. The higher the mortgage interest rate the borrower pays, the higher the return the investor gets.

Conforming mortgage securities are guaranteed by Fannie Mae or Freddie Mac to pay a minimum return to investors - which makes them a fairly safe investment, though not quite as safe as Treasury securities. Therefore, to attract investors, they have to pay a somewhat higher interest rate than Treasury securities do.

When interest rates on Treasury securities are down, mortgage securities can reduce the rate they need to pay to attract investors - which means mortgage interest rates go down as well. When interest rates on Treasuries go up, mortgage securities need to raise the rates they pay in order to compensate investors for the added risk they're taking on compared to Treasuries - so mortgage interest rates charged to borrowers increase as well.

Fed purchases crowded out usual investors

Rates dropped to record lows last year after the Federal Reserve announced it would buy $1.25 trillion in mortgage securities. As in the example above, by driving up demand for mortgage securities (and $1.25 trillion is a lot of demand!), it drove down interest rates.

These purchases were made in installments over the course of about one year, gradually winding down until ending on March 30, 2010. Most observers predicted that rates would begin rising as soon as the Fed withdrew its support. In late February, the Mortgage Bankers Association predicted that interest rates on 30-year fixed-rate loans would hit 5.7 percent by the end of the second quarter of 2010. Instead, with the second quarter drawing to a close, they've dropped below 5 percent again and there are signs they may go still lower.

Rates did jump up briefly in early April, but immediately settled back down again. One of the things that happened is that the Federal Reserve's purchases had crowded out a lot of investors who normally invest in mortgage-backed securities. Once the Fed backed off, these investors came back in to rebuild their portfolios. Again, higher demand means lower interest rates.

Shortly after, the Greek debt crisis developed, which, coupled with some of the other situations mentioned above, increased the risk associated with stocks and other high-return investments. So investors sought the safety of Treasuries and other interest-bearing investments, like mortgage securities, again increasing demand and lowering rates.

When will rates head back up?

So when will rates increase? It's difficult to provide a date, but the circumstances that would trigger an increase are pretty clear. One of the big ones would be signs of inflation, which has remained extremely subdued despite heavy stimulus spending to jolt the economy. When inflation kicks in, interest rates always soar to preserve the value of investments.

Other factors include when the economy shows signs of strengthening and the stock market begins to climb, indicating that investors are willing to take on more risk, meaning safer investments will have to pay higher rates to draw their interest. A resolution or calming of the Greek debt crisis would likely be a factor here.

In the meantime, mortgage rates remain near all-time lows and continue to offer opportunities for buyers and homeowners who wish to refinance. Those who may have been turned down for a refinance at last year's rates might consider trying again, because stabilizing home values may make lenders more willing to consider loans they previously rejected.

Published on May 29, 2010