Inflation and Mortgage Rates Explained

What's the connection between inflation and mortgage rates?

As you know, inflation is a measure of how much prices increase over time. It's measured by an indicator called the CPI, or Consumer Price Index. Mortgage rates are what home buyers pay for mortgages, which come in all-fixed , fixed/ARM , and ARM (adjustable rate mortgages) forms. [Clarification: fixed/ARM and ARM are the two types of adjustable rate mortgages].

For example, when you hear somebody say that they're going to shop around for the best mortgage rates, what they're talking about is finding a lender who will give them an all-fixed or fixed/ARM loan rather than an adjustable rate mortgage. Since most lenders don't give ARMs anymore, either due to new regulations or because they can make more money from all-fixed loans, people who want to get a fixed/ARM or ARM have to ask for them specifically.

Inflation and Mortgage Rates Explained - Full

Inflation is a measure of how much prices increase over time. It's measured by an indicator called the CPI, which stands for Consumer Price Index. Mortgage rates are what home buyers pay for mortgages, which come in all-fixed , fixed/ARM , and ARM forms. When you hear somebody say that they're going to shop around for the best mortgage rates, what they're talking about is finding a lender who will give them an all-fixed or fixed/ARM loan rather than an adjustable rate mortgage. Since most lenders don't give ARMs anymore, either due to new regulations or because they can make more money from all-fixed loans, people who want to get a fixed/ARM or ARM have to ask for them specifically.

Okay, so what's the connection between inflation and mortgage rates? Well, in short, when the CPI goes up, lenders usually raise their mortgage rates . This makes sense when you think about it. If prices are increasing at a higher rate than normal, then banks need to charge more in order to make the same amount of money. That way, they don't take a loss on their loans .

Many people think that inflation is bad for homebuyers. It's true that one reason it's bad is because it raises your monthly payments . However, it also has other effects that are just as important, if not more so. For one thing, inflation is bad for fixed-rate mortgages . That's because if inflation goes up, so do your payments . Meanwhile, the value of your home might not have increased at all, especially in areas where homes are already expensive. This means that you're actually less likely to be able to sell your home after a few years of living there, which can really hurt you if you want to move.

Another reason that inflation is bad for homebuyers is that it makes credit more expensive . If lenders know that the CPI has increased and will probably continue increasing, they're going to charge more interest on all of their loans , including mortgages. This means that even people who don't want to refinance their current loan might struggle to get a new one if inflation is high.

Lastly, inflation can increase the costs of borrowing money for states and local governments . This makes it more difficult than usual for lawmakers to balance their budget , which has all kinds of negative effects on taxpayers . It also means that if your city needs to borrow money to fund its budget, it's going to cost them more than they would have otherwise.

Okay, so inflation is bad for homebuyers . But can't we do anything about it? Well, you could try buying gold , but even that might not be enough. The Federal Reserve tries to control inflation by adjusting interest rates . When they need to stimulate the economy , they increase interest rates, which reduces inflation. However, when they need to slow down economic growth , they decrease interest rates, which causes inflation to go up. There's a trade-off between the two, and unfortunately for homebuyers , it usually means that mortgage rates are going to rise when the Fed wants to cut inflation.

What if the Federal Reserve adjusts interest rates and it doesn't affect inflation? Well, there's a third thing that they can do: buying and selling Canada Treasury bonds and bills . For example, if we had high inflation but very low unemployment , what would you expect them to do? They might buy lots of Canada Treasury bonds and bills to stimulate the economy, which would cause even more inflation. On the other hand, if we had low inflation but high unemployment , they might sell off most of their Canada Treasury bonds and bills instead. Either way, you can expect interest rates to rise.

If your loan is due in several years or less, then the Fed's actions are probably not going to affect you , one way or another. However, if your loan is due in several years or more, it makes sense to keep an eye on what Canada Treasury bonds and bills are doing. Why? Well, for one thing, that's how economists can tell whether inflation is primarily driven by the Fed or by the market.

For example, let's say that there's high inflation and low unemployment at the same time. Furthermore, Canada Treasury bonds and bills are mostly being purchased right now . What would you expect to happen? Well, you might still expect mortgage rates to increase , because it takes a while for the Federal Reserve Board to adjust interest rates. However, at this point, the market is likely to adjust faster than the Fed Board. In other words, Canada Treasury bond prices are probably going to go down , while mortgage rates are likely to stay high .

On the other hand, what if there was low unemployment but high inflation? Well in that case, you might expect Canada Treasury bond prices to go up, while mortgage rates stayed low in anticipation of the Fed Board adjusting interest rates.

Generally speaking, if the Federal Reserve Board is in control , you can expect interest rates to move in line with inflation .