How QE keeps your mortgage interest rate down

The average interest rate on a 30-year mortgage has dropped to 4.22 percent. That's down from 4.35 percent last week.

Good news for those who believe that an improving housing market is key to our economic recovery.

One caveat: That 4.22 percent is not the flat rate that people paid. It includes points paid up front by borrowers. Regardless, the rate is still falling, which means that it's getting cheaper for people to borrow, which means they're more likely to buy.

Yesterday, we learned that outgoing Federal Reserve Chairman Ben Bernanke is committed to keeping interest rates low. To date, the Fed has done this via quantitative easing, in which the Fed buys huge amounts of bonds every month.

But how does the Fed's bond splurge translate into movements in your mortgage rate?

Rather than talk about bonds, let’s talk about fruit. Imagine a big ol’ fruit market, full of consumers. There are all sorts of fruits for sale, but apples and oranges are the biggest sellers: People love 'em, and there is always plenty of demand. The market owner has loads of apples and oranges to sell, but he wants to make a bit more of a profit on them. His solution: Send in his nephews every afternoon to buy whole crates of the fruit. As supply dries up, he's able to mark the fruit up and make more money.

The Fed does something similar with bonds, both long-term treasuries and mortgage-backed bonds issued by Fannie Mae and Freddie Mac (so-called “agency bonds”). There are loads of those bonds for sale, and usually prices are low. But the Fed wants to make those bonds more expensive, and it does that, just like the market owner’s nephews, by stepping in and buying $85 billion worth of agency and long-term Treasury bonds every month. And just like shoppers in the fruit market, investors are left to fight over what's left.

Why does the Fed do this? Because it wants to create more demand for those bonds. And more demand equals higher prices. Remember bonds 101? Higher prices means falling yields, which means that new bonds issued by Fannie, Freddie and the government can be priced with lower interest rates.

Now stay with me here! Mortgage interest rates are set in large part by Fannie and Freddie: These agencies buy mortgages and package them into bonds, which they then sell to investors. The interest rates on the mortgages they buy – the mortgages for your house, and mine – depends on the interest rates they have to pay to the investors who buy Fannie's and Freddie's mortgage-backed bonds. So if they're able to cut the interest rate on those bonds, they can also cut the rate on our mortgage.

And that’s how QE can drive our mortgage interest rates down.

About the author

Paddy Hirsch is a Senior Editor at Marketplace and the creator and host of the Marketplace Whiteboard. Follow Paddy on Twitter @paddyhirsch and on facebook at www.facebook.com/paddyhirsch101

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