Colorado Mortgage Broker

Scared of Inflation?  Here's Why You Should Be - Inflation and Mortgage Rates

Inflation is the sleeping giant that has not yet come alive.  We have enjoyed low inflation and low mortgage rates for over a year now, and in some months deflation has been reported.  However, it seems inevitable that inflation will rear it's ugly head at some point in the not-too-distant future. 

Inflation and Mortgage Rates are related in how they move, so it is not a surprise that the low inflation of the past couple years has led to low rates.  Higher inflation could lead to higher mortgage rates, and perhaps extremely high mortgage rates- a scary proposition with signs of life emerging in the economy.

So the question is- Why is inflation a threat?  And why are Inflation and Mortgage Rates related?

Inflation is a threat for one because of the amount of money that the government has been printing in order to fund the stimulus bills that they have passed.  The stimulus money has had to come from somewhere, and that somewhere has been in the form of US Bonds that have been sold on the secondary market. 

The laws of supply and demand can show why this is bad for future inflation.  More money in circulation means that it takes more of that money to buy the same item.  More money to buy the same item = higher prices in relation to the value of a dollar.  Also, with commodities for the most part tied to the dollar, as the value of a dollar declines, the price of goods goes up proportionally.  This leads to higher prices (inflation).

It is the consensus that inflation will arrive in the future, and perhaps as early as this summer.  The fear is that we could see a period of hyperinflation like in the late 70's/ early 80's.  Hyperinflation means extremely high levels of inflation which is hard to get under control.  When this happened 3 decades ago, extremely high mortgage rates followed, showing that Inflation and Mortgage Rates are correlated.

So then why are Inflation and Mortgage Rates related?  Why do rates go up when inflation goes up?

The first concept that must be understood is that mortgage rates are tied to mortgage-backed securities, or mortgage bonds, that are bought and sold in the markets.  Mortgage bonds back the mortgages that all of us have on our homes.  Bonds are bought and sold with a certain note rate, which gives a certain rate of return for the investor.  This rate determines the rate that banks can offer on mortgages which are backed by the bond. 

To hopefully keep it simple, let's say you close on your home loan at a 5% interest rate, good for 30 years, which means, in basic terms, that the mortgage company makes 5% per year on their investment before inflation.  If inflation sits at a calm 1.8% or 2%, that means that the mortgage company makes a decent margin of 3% on their investment when adjusted for inflation.  This is because at an inflation rate of 2%, a dollar buys 2% less a year from now than it does now.

So when inflation starts to rise again, the margin that the mortgage company will make will start to decrease.  If inflation rises to 3%, the mortgage company is only going to make a 2% margin.  If inflation climbs to 5%, the bank will have no margin.  Unlikely a bank will want to lend money with no profit.  Therefore, they must raise their rates (and the corresponding rates of return on mortgage bonds will also have climbed), in order to realize a profit.  Inflation is the killer of long-term investments such as mortgage backed securities.

Will inflation start to rise soon?  Hard to predict the future, but it seems inevitable, and with Inflation and Mortgage Rates so closely related.  We can only hope for the sake of the housing recovery that it doesn't rise too much.  A significant increase in inflation could lead to another downturn in the economy and with Inflation and Mortgage Rates so closely tied, we could see scary mortgage rates in the not-too-distant future.

We are watching the markets every day and will inform you of mortgage rate movement and the best time to secure your rate.  Sign up for our Mortgage Market Updates through twitter!