Most readings of historical mortgage rates?would tell you that mortgage rates today are extraordinarily low. Is there room for an opposing viewpoint? The answer is yes -- you could argue that relative to inflation, today's mortgage rates are higher than normal.
It's always good to seek a contrarian viewpoint on financial topics. It's not that the contrarian view is necessarily right -- it's good to understand what holes there might be in the logic of conventional wisdom. After all, financial markets are at their most dangerous when everyone seems to be in agreement.
In this case, the contrarian viewpoint doesn't necessarily indicate that mortgage rates will fall. What it does, though, is point to a key variable besides mortgage rates that potential mortgage shoppers should be watching.
Historical Mortgage Rates and Inflation
Any interest rate, including mortgage rates, consists of essentially two components. Part of the interest rate is there to keep pace with inflation, so the lender does not lose purchasing power over the life of the loan. The other part of the interest rate compensates the lender for taking the risk of making the loan. This latter component can be referred to as the risk premium.
Both components are variable, but since inflation is measurable, we can use it to get a feel for whether the second component of an interest rate is relatively high or low. In other words, when inflation rises or falls, we would expect that mortgage rates would rise or fall by a similar amount, unless that second component is also expanding or contracting.
Conveniently, mortgage rates historically seem to break out about evenly between the two components. Dating back to the early 1970s (when a consistent mortgage data series first became available from the Federal Reserve), mortgage rates have averaged about 9%, and the average yearly inflation rate in the same period has been almost exactly half of that, or around 4.5%. Therefore, the other 4.5% must be the second component, the compensation given to the lender for making the loan.
Of course, it's a little more complicated than that. For instance, mortgage rates, for the most part, are set at the beginning of the loan, whereas inflation rates vary throughout the loan. Interestingly, while you may dread inflation under most circumstances, as a borrower it is good for you. If inflation rises over the course of your loan, it diminishes the value of your debt in purchasing power terms. To think of it another way, assuming your earnings roughly keep pace with inflation over time, rising inflation over the course of your loan makes the debt easier to pay off.
If borrowers benefit from inflation over the course of a loan, then lenders suffer. Part of that second component of the mortgage rate, the compensation to the lender, serves as a hedge against the risk of rising inflation.
Today's Mortgage Rates and Inflation
As described above, mortgage rates historically have been about 4.5% above the prevailing inflation rate. At the moment, however, even though mortgage rates are low, they are unusually high when compared to inflation. This is because we've actually had deflation, or a negative inflation rate, over the past year.
The US Bureau of Labor Statistics reported a 1.3% rate of deflation for the month of September 2009. Adding that to a 5.21% average 30-year conforming mortgage rate (the average 30-year fixed mortgage rate for the same month), recent mortgage rates were actually 6.51% above inflation, or significantly higher than the historical 4.5% risk premium. So even though it may be counterintuitive to say it, today's mortgage rates are actually higher than usual, at least by one measure.
Other Variables in Today's Mortgage Rates
It's important to note that when referring to today's mortgage rates, or historical mortgage rates for that matter, the benchmark that is used is a conventional conforming 30-year mortgage rate. However, at any given time, mortgage rates vary by region, size of the loan, and the credit standing of the borrower. HSH.com can provide you with mortgage rates that apply to your particular financial situation. However, using the standard benchmark rate is useful for getting a sense of where today's mortgage rates generally stack up against historical rates.
One final but crucial note: the argument that today's mortgage rates are actually on the high side relative to inflation is not necessarily a forecast that mortgage rates are primed to fall. The other variable in the relationship -- inflation -- could also change. If inflation were to rise, the key question would become whether the higher risk premium would remain in place. If it does stay the same while inflation increases, the sum of the two would mean rising mortgage rates. As for the likelihood of inflation rising, that's a question hotly debated in the financial press.
About the Author
Richard Barrington is a freelance writer and novelist who previously spent over twenty years as an investment industry executive.