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Inflation Affects Mortgage Interest Rates In What Ways?

By Kevin Landis

Mortgage interest rates are affected by inflation. Let’s begin by defining terms.

Inflation

Increase in the cost of goods and services over a period of time; the decrease in the purchasing power of money. – wikipedia.org

Mortgage Interest Rate

The rate at which interest is paid on a home loan by a borrower for the use of money that they borrow from a lender. – wikipedia.org

How Inflation Affects Mortgage Interest Rates

The holder of a mortgage expects to realize a predetermined rate of return. Inflation eats away at this return and the inherent value of a mortgage. If the rate of return is 6% and the rate of inflation is 2%, the effective rate of return is 4%. As inflation increases to 3%, the rate of the return drops to 3%. This has a dramatic effect on the rate of return of fixed rate investments. Mortgage interest rates are driven higher in order to realize the same 4% rate of return required by the mortgage holder.

The Federal Reserve and Inflation

The Federal Reserve calculates the rate of inflation through the use of the Core PCE Index. The Personal Consumption Expenditures Price Index (PCE) follows what we spend minus food and energy due to volatile price fluctuation and seasonality. The current index is compared to the index of the previous period and indicates the rate of inflation. Rising inflation is indicative of a growing economy. The Federal Reserve has the power to raise interest rates in an effort to preserve a consistent growth rate.

Conclusion
A rising PCE Index indicates rising inflation, and mortgage interest rates will most likely follow. In addition to higher mortgage interest rates, a home buyer’s monthly loan payment will rise and limit the amount of loan available.

Related posts:

1. Who Affects Mortgage Interest Rates?
2. Does Inflation Affect Mortgage Interest Rates?
3. Do Consumer Price Index & Mortgage Rates Conflict Each Other?
4. How Do Mortgage Interest Rates Affect Inflation?
5. What Affects Mortgage Rates?