Ever wonder why inflation hurts mortgage rates? There’s a simple reason behind this antagonistic relationship that may surprise you. So simple – it only took the 484 words in this blog to sum it up.
First – Mortgage Rates & Bonds Are Connected
Before making common sense of inflation and higher mortgage rates, the mortgage rate & bond link must be understood. Afterall, inflation weakens a bonds financial “power” which then often influences rates.
In short, mortgage rates improve (mean go lower) when mortgage bond pricing increases. Also, the opposite is true – lower bond prices result in higher mortgage rates. In other words, home loan interest rates are tied to mortgage bonds.
What are Bonds & What is Inflation?
Bonds represent secure, long term low yield investments. In other words, while bonds don’t earn you a lot they guarantee a low rate of return over time. They’re a safe place to “park” money and let it grow a little.
What about inflation? Inflation is the increase in the cost of goods and services over time. For example, high inflation means a gallon of milk will cost more next year than it does today.
Inflation’s Impact On Bonds
Assume you invest $100.00 in a bond guaranteeing a 1.25% rate of return. In 1 year your $100.00 will be worth $101.25. In other words, the future purchasing power of your $100.00 is $101.25 in 1 year.
Now, imagine 3% inflation over that same year your bond earned 1.25%. The cost of goods and services increase by 3% next year compared to today. That same widget costing you $100.00 today costs an inflated $103.00 – 12 months down the road due to inflation.
In this example, inflation grew faster than your bond investment. On day 1 your $100.00 would buy the $100.00 widget. However (and this is key), 1 year down the road that travelled through 3% inflation your bond investment is now worth $101.25. As a result, it no longer is enough to pay for the widget now costing $103.00. What happened? Inflation outpaced your bond’s rate of return reducing your bond investment money’s purchasing power.
Why Does Inflation Hurt Mortgage Rates?
Ok, so inflation reduces how much money invested in bonds can buy over time. Got it. Why does that impact mortgage rates you ask?
When investors sense high inflation, low yield bond investments become less attractive. They may pull money out of bonds and put it somewhere else. For example, investors might move money into a mutual fund that presents a better shot at out earning inflation.
As the demand for mortgage bonds falls so does the price. As discussed above, falling mortgage bond prices result in higher mortgage interest rates. Ultimately, investors fleeing bonds make bond prices drop and the result – higher mortgage rates.
See – simple! Inflation tends to drive higher mortgage rates ;). Also, there are a multitude of other factors besides inflation that impact mortgage bond pricing and mortgage rates.