Maybe everything is returning to normal, or maybe we are still defining a new normal. What is certain is that the economy is changing. One area to keep a close eye on is whether the current surge of inflation will also bring a surge in mortgage interest rates. There is a very good reason to watch this metric because the rate of inflation traditionally remains below the rate for a 30-year mortgage. That is not the case today. Today, inflation is higher than mortgage interest rates.

Lenders Have to Charge More Interest Than the Rate of Inflation

Mortgages are all about the future value of money and the future value of money is a very good reason why inflation should be less than mortgage rates. Inflation means that a dollar tomorrow will buy less than today’s dollar. While mortgage rates and inflation are not directly related, there is a very close connection. Banks lend money to make a profit. If the value of the money they lend today will be worth less in the future, banks need to charge a higher rate of interest to maintain the same value tomorrow. Keeping up with inflation means that mortgage interest rates need to be at least equal to the rate of inflation. To make a profit, banks need to charge a higher interest rate than the rate of inflation.

That’s why lenders like adjustable-rate mortgages (ARM) during times of high inflation. An ARM allows the lender to periodically adjust the interest rate in relation to inflation. With 30-year mortgages, the interest rate is locked in for a very long time without the ability to adjust for inflation. That is the economic reason why 30-year mortgage fixed rate mortgages need to be higher than the rate of inflation. The same logic applies to 10-year, 15-year, and other fixed rate mortgages.

Why Today’s Inflation Might be Temporarily Different

According to the U.S. Labor Department data published May 12, the annual inflation rate for the United States is 4.2% for the 12 months ended April 2021. But 30-year fixed rate mortgages continue hovering at about 3% and have recently even dipped slightly below that. This is contradictory to the economic rule that mortgage rates need to be higher than the rate of inflation.

This is the first time since August 1980 that U.S. inflation was running hotter than mortgage rates. That should get your attention because it was more than 40 years ago and interest rates were running at about 15%. Most of today’s homebuyers have no memory of the time when mortgage rates were anywhere close to 15%. It was at this same time when the Federal Reserve began an aggressive strategy to tame runaway inflation. But this isn’t 1980 and interest rates are not hovering around 15%. So, what is different?....

Enter the new world of the pandemic. The reason that inflation recently jumped so much is that the numbers are compared on a year-to-year basis. Inflation looks high today in comparison to the deflation that we experienced at this time last year when the economy was at a standstill. First, consumer prices had to recover to what they were a year ago and now there is some inflation on top of that. But the real inflation is probably less than the official year-on-year increase of 4.2%.

The widely held belief is that April's high inflation is likely just a temporary occurrence, not a trend. Mortgage rates shouldn't spike until inflation stays high for a relatively long amount of time, at least a few months.

But We Don’t Know the Future

Homebuyers and everyone that could be impacted by mortgage interest rates should keep a close eye on what the inflation rate does for the next several months. In fact, mortgage rates really can’t be expected to go much lower unless the economy does into a nosedive rather than continuing to recover.

Remember inflation is a measure of consumer prices. There are warning signs that prices could continue to rise. In the U.S. and around the globe, massive government stimulus pumped money into the bank accounts of consumers. At the same time, prices of homes and stocks have soared, making affluent consumers richer.

If consumer prices (inflation) do not moderate in the next couple of months, mortgage rates can be expected to increase significantly. Increases won’t skyrocket to the 15% level of the 1980s but 5% and 6% might be expected.

Opinions for the future rate of inflation and mortgages are mixed. Janet Yellen, the former head of the Fed and current Treasury secretary, recently warned that the U.S. economy could overheat. On the other hand, current Fed Chairman Jerome Powell isn’t as worried.

The bottom line is that most economists are taking a wait-and-see attitude towards inflation and mortgage rates. One important point is that the most likely direction for mortgage rates is higher, while the best scenario is they will remain stable at close to 3%. Of course, homebuyers are facing other significant cost increases. The median price of home resales soared a record 19% from April 2020 to April 2021, after jumping a record 17% from March 2020 to March 2021. That is where we are seeing increases at 15% and above. Home prices are clearly not directly reflected in the consumer price index.

Please share your thoughts about the near-term cost of home purchasing by leaving a comment.

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Image by Gerd Altmann from Pixabay