Thirty-year mortgage rates were over 7 percent at the end of August 2023, a level not seen (other than two isolated weeks) since 2002. Why are mortgage rates so high?
Factors commonly mentioned are important. Interest rates are higher due to the Federal Reserve’s increases in rates from their near-zero levels. These higher rates indicate some combination of higher expected inflation and higher expected real interest rates.
These higher short-term rates are reflected in higher long-term rates and higher yields to maturity on government bonds. This indicates that the higher short-term rates are expected to persist.
Mortgage rates are most commonly compared to yields on 10-year government bonds. While 30-year mortgages could potentially be paid off after 30 years, most mortgages are paid off much sooner. The maximum possible term to maturity for mortgages is much longer than the actual typical term to maturity. Government bonds are nominally risk free and risky mortgages can be usefully compared to them. The 10-year government bond is used for comparison instead of other bonds because the 10-year bond has a more similar maturity than it might seem and because it is much more liquid than longer-term government bonds.
The figure above shows why the 10-year government rate is used for comparison. Many of the larger and even smaller changes in 10-year government bonds are reflected in 30-year mortgage rates. Hence, part of the recent rise in mortgage rates simply reflects the rise in risk free long-term interest rates, such as the 10-year government bond yield.
The thirty-year mortgage rate hit its lowest level in 30 years the week of January 4, 2021; the rate was 2.66 percent. Since then it has risen to reports of rates as high as 7.5 percent last week. The 30-year mortgage rate averaged 7.09 percent for the week ending Thursday, April 14. This is an increase of 4.44 percentage points from the rate in January 2022. Over the same period, the yield on 10-year government bonds increased quite a bit also, but only 3.23 percentage points. The spread between the mortgage rate and the 10-year government bond yield has widened from 1.66 percent to 2.86 percentage points.
The figure below shows the spread between the 30-year mortgage rate and the 10-year government bond yield. (The spread with the 30-year government bond yield is similar.) Clearly the rise in risk-free government interest rates is not the sole explanation of the increase in mortgage rates.
If the mortgage rate had risen only as much as the 10-year government bond’s yield, it would be 5.89 percent. There is little doubt that a mortgage rate of 5.89 percent instead of 7.09 percent would make a big difference to many borrowers.
Why has the spread increased? The increase in the spread is unusual but not unprecedented. As recently as the week ending April 20, 2020, the spread was 2.71 percentage points. The increase in the spread to 2.71 percentage points in 2020 is not surprising. The United States economy was contracting, with a recession from February 2020 to April 2020 and an unemployment rate of 14.7 percent. Recessions make it harder for people to make their mortgage payments and mortgages become riskier investments. The increase in the spread in 2008 is also associated with a recession.
The increase in the spread in 2023 is not associated with a recession.
The recent increase in the spread is due to a decrease in the demand for mortgages for reasons other than a recession. Silicon Valley Bank, which failed earlier this year, held long-term securities which fell in value as yields rose. Perhaps partly because of concern about interest-rate risks going forward, banks have decreased their holdings of mortgages. Since the week ending February 23, banks’ holdings of mortgage-backed securities issued by the federal government have fallen 14 percent. No doubt other holders of these securities also now view them as risky, even if they don’t have to dispose of them due to concerns about regulators.
Beyond the unfortunate implications for home buyers, especially first-time home buyers, what can be learned from this episode? Interest rates on mortgages were 2.66 percent just two and a half years ago. Why the sudden increase in rates? The Federal Reserve increased the money supply and generated the worst inflation in many years. Additionally, the Federal Reserve was attempting to manipulate interest rates to encourage interest-sensitive activities. That part of the plan worked. The unexpected outcome is that the perceived interest-rate risk of long-term mortgages now is much higher and mortgages are more expensive than they would have been otherwise.
Besides these effects, many people have very low rate mortgages; they will be reluctant to sell their homes and pay off those low-rate mortgages for some time. While good for those who have such mortgages, the low rates on existing mortgages will discourage people from selling their homes and giving up the mortgages. This will reduce purchases and sales of existing homes and make it even more difficult for first-time home buyers to buy a house.