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Why Do Mortgage Rates Fluctuate -- and How Can You Predict Changes?

Can you predict the future direction of mortgage rates? Nobody can do that wholly accurately all the time. As the late Harvard economist John Kenneth Galbraith once observed, "The only function of economic forecasting is to make astrology look respectable."

But if you know the influences that cause those rates to fluctuate, and you keep your eye on them, the educated guesses you make might give you some valuable insights that might help you make smart borrowing choices -- at least in the short term. Unfortunately, that involves a lot of work: constantly monitoring markets, following trends, reading financial analyses, visiting government and other websites for the latest data. So it's just as well that LendingTree already does that for you, and publishes each working day a new Mortgage Rate Lock Recommendation for the following 30 days, which includes a roundup of the latest news and analysis. Nevertheless, as an intelligent and curious person, you'd probably still like to understand how and why these rate fluctuations occur.

How Your Rate's Determined

The mortgage rate you end up paying comprises three main elements:

  1. A prime rate, which may be specified in your loan agreement
  2. A personal "spread," which is an amount on top of the prime rate your lender wants for the risk of lending to you personally
  3. An economic "spread," which is an amount on top of the prime rate determined by a wide range of economic factors.

If you already have a fixed-rate mortgage, you needn't be bothered by any of these, once your rate's locked. But if you have an adjustable-rate mortgage (ARM), you could find the first and last of them endlessly fascinating. (The middle one rarely rears its head once a rate is locked.)

By the way, ARMs usually have caps that limit rate increases both at any one time and over the lifetime of the loan. So in a sense those are a fourth element, though only for those borrowers affected.

The Prime Rate

If you think of a mortgage rate as a pyramid, the Federal Reserve forms the base. It sets rates at which depository institutions lend to each other overnight (the federal funds rate) and borrow from the Fed's own regional lending facilities (the discount rate). When these go up and down, pretty much all other rates do too. They've been at historical lows for many years now, but the Fed is at the time of this writing signaling that it will begin to gradually increase them, probably starting in September 2015.

Lenders may be able to borrow at the Fed's discount rate, but they need to make a profit and cover the risk that all lending brings. To cover those, they add a premium: a "spread." The spread they add for their lowest risk customers (think of the biggest, most successful global companies imaginable) can be relatively small, and the rate they charge those is called the prime rate. It's also known as the base rate or reference rate. Each lender can set its own prime rate, though some use the one published daily in The Wall Street Journal. According to the Fed, the average prime rate charged by the

top-20 lenders has held steady at 3.25 percent since 2009. That's almost bound to rise in line with those federal rate increases that are expected later in 2015.

Your Personal Spread

Because you're not one of the biggest, most successful global companies imaginable, lenders won't want to offer you the prime rate. They're going to want to add a spread to cover the additional risk you represent: the possibility that you might default or pay back your loan early. This is the one element of your rate you yourself can safely predict and alter.

The higher your credit score and the bigger your down payment, the lower the risk of a loss to the lender -- and almost certainly the lower the rate you're offered.

The "Economic" Spread

This is where it gets complicated. At its simplest, the economic spread is determined by the laws of supply and demand: how many people want to borrow to buy homes and how much, and how many investors want to invest in mortgages and how much. If lots of people want to borrow, and few want to lend, rates rise -- and vice versa.

The demand end is affected largely by consumer confidence: You're unlikely to want to borrow to buy a home if you're worried you're going to lose your job or have to take a pay cut, or if you think the economy is in trouble and home prices could tank. Although demand ebbs and flows, it tends to do so gently.

The supply end is the source of most of the volatility in mortgage rates. Investors (mostly managers of pension and other huge investment funds) seek to balance the risk and reward within their portfolios, and constantly monitor markets and economies around the world to minimize the risk and maximize the reward. A crisis in Europe or Asia (or America) can see them pouring money into safer American investments, the safest of which are U.S. Treasury bonds. The home loan market here is also seen as fairly safe, to the extent that mortgage rates are closely tied to the 10-year flavor of those bonds. Extra demand for bonds drives their "price" up, meaning lower yields -- and lower mortgage rates.

When economic data are good, and there are fewer threats to portfolios, investors tend to look for the better returns they can get from more risky investments. So then bond yields often have to rise to remain competitive, and, again, mortgage rates follow them.

Endless Complexities

Various other factors -- notably inflation and government interventions -- can also influence rates, and some combinations of circumstances can work against those simple supply-and-demand rules. Frustratingly for forecasters, things that would normally be expected to trigger a rise can actually produce a fall -- or the other way around.

This can sometimes make forecasting rates feel, as Professor Galbraith suggested, little better than astrology. However, at least during economically stable times, you can, by closely following data and trends, make reasonably accurate and educated guesses about the direction mortgage rates might follow in coming days and weeks. But you may prefer to read LendingTree's rate lock recommendations instead.

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