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The Real Reason Mortgage Rates Are Rising

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For the past year both home prices and real estate sales have been rising but now we've hit a bump that could change the entire marketplace: Mortgage rates are soaring.

Look at what happened with mortgage rates in May. According to Mortgage News Daily a 30-year fixed-rate loan had an interest cost of 3.41 percent on May 1st. The same loan was priced at 4.0 percent by May 31st.

That's up 17.3 percent. In a month.

These are not just academic numbers. In real terms the cost for principal and interest with a $200,000 mortgage rose from $888.07 to $954.83. This may not seem like a lot but it's enough to knock marginal borrowers out of the marketplace and with fewer buyers there's less pressure to push prices higher.

So what happened? Why the sudden rise in rates? And will mortgage rates continue to rise?

Last September the Federal Reserve announced that it would begin purchasing mortgage-backed securities (MBS) worth $40 billion a month — that was in addition to the $40 billion a month it was already buying. The result was that lenders could originate qualified mortgages at the rate of $1 trillion a year ($85 billion x 12) and know that the Fed would buy from them.

Having a strong and assured buyer pushes down interest rates — Freddie Mac says 30-year fixed mortgage rates reached historic lows in late 2012. One reason for such low interest levels, according to Federal Reserve Governor Jeremy C. Stein, is that mortgage rates dropped 0.2 percent when the Feds announced the new purchase program.

The problem with the Federal Reserve action is that it raised several questions:

First, did the banks really need more government help? That's essentially what the Fed has been doing with its purchases.

Second, is the Fed going to purchase mortgage-backed securities at the rate of $85 billion a month forever? If not, when will it slow down or stop?

Some investors thought they had an answer to the second question last month from a speech by Federal Reserve Chairman Ben Bernanke.

“In light of the current low interest rate environment," said Bernanke on May 10, “we are watching particularly closely for instances of 'reaching for yield' and other forms of excessive risk-taking, which may affect asset prices and their relationships with fundamentals.”

Was this a signal that the Fed was tapering down its buying spree? Given the obtuse language used by Bernanke no one could say for sure — but the implication made bond buyers shudder. If the Fed was even thinking of buying fewer mortgage-backed securities then mortgage rates would have to rise.

The problem with Fed purchases is not that mortgage-backed securities cannot be sold — the world is awash in cash — instead, the issue is that private investors want more interest because their motivations are different from the Fed. If those who buy mortgage-backed securities want more interest then it follows that the mortgages which make up such securities must have higher rates as well.

What comes next in terms of mortgage rates and home sales?

Nobody knows for sure, but it can be argued that a return to the record-low interest rates seen in 2012 is unlikely. Also unlikely are real estate price increases at the rate seen during the past 12 months — the National Association of Realtors says existing home prices in April were 11 percent higher than a year earlier.

So more real estate sales? Yes. Higher general home prices? Probably in most areas. A rate of price increases similar to that seen during the past year? Not likely.

Meanwhile, at this writing we only have hints regarding what the Fed might actually do. If the Fed has begun to reduce its MBS purchases then at least some of the sting has already been anticipated by the marketplace, and that's the major reason we now have higher rates than just a few months ago.


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