Why weakening inflation is good news for mortgage rates

Posted by  on Jun 28, 2012

Today's mortgage rates are near record lows, but when viewed in the context of inflation, they may not be as extreme as they appear. For people who want to buy a house or refinance but aren't quite ready to do so, the latest news on inflation may be good news, as it suggests low mortgage rates may have some unexpected staying power.

The premium over inflation

To the average borrower, the interest rate on a mortgage is taken a face value. For example, if you were comparing mortgage quotes, a rate of 3.80 percent would clearly be cheaper than a rate of 4.11 percent. In part, that's because most people only take out one mortgage at a time, so they are focused on mortgage rates at that one point in time.

Mortgage lenders, on the other hand, make a variety of loans at different times, which means they are making loans under a constantly changing set of inflation circumstances. Those inflation circumstances are vitally important to a lender's profitability.

In order for a lender to make a profit, that lender has to earn a premium over inflation. So, to the lender, what really matters is not the mortgage rate at face value, but the mortgage rate compared to the inflation rate.

Changing inflation trends

What the above means is that mortgage rates have to be viewed in the context of inflation. This can greatly alter the perception of mortgage rates.

For example, in September 2011, 30-year mortgage rates averaged 4.11 percent, while the year-over-year inflation rate was at 3.9 percent. To mortgage lenders, this meant the prospect of earning just 0.21 percent over the rate of inflation.

By May of 2012, the inflation picture had changed markedly. Thirty-year mortgage rates had dropped to an average of 3.8 percent, but year-over-year inflation had dropped to just 1.7 percent. From a lender's perspective, this meant the prospect of earning 2.1 percent over the rate of inflation -- 10 times the inflation premium from the previous September.

Why should a borrower care about a lender's inflation premium? Because as long as lenders are earning a healthy margin over inflation, they have no compelling reason to raise their interest rates. So, as long as inflation continues to fall, low mortgage rates may be safe for a while longer.


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