How Does Inflation Impact Mortgage Rates?

[Article taken from 2007 edition of "The Borrower's Bible" written by Todd Gehrke]

CHAPTER 14: WHAT ARE BONDS?

Bonds are fancy IOUs.

Companies and governments issue bonds to fund their day-to-day operations or to finance specific projects. When you buy a bond, you are loaning your money for a certain period of time to the issuer, be it General Electric or Uncle Sam. In return, bond holders get back the loan amount plus interest payments. Mortgage-backed securities are debt obligations that represent claims to the cash flows from pools of mortgage loans, most commonly on residential property.

In exchange, the borrower promises to pay you interest every year and to return your principal at maturity when the loan comes due. The length of time to maturity called the term. A bond's face value, or price at issue, is known as its par value. Its interest payment is known as its coupon. A $1,000 bond paying 7% per year has a $70 coupon (actually, the money would usually arrive in two $35 payments spaced six months apart). Expressed another way, its coupon rate is 7%. If you buy the bond for $1,000 and hold it to maturity, the annual yield, or actual earnings on your investment, is also 7% (coupon divided by price = yield).

The prices of bonds fluctuate throughout the trading day, as do their yields. But the coupon payments stay the same. Say you don't buy the bond right at the offering, and instead buy from somebody else in the secondary market. If you buy the bond for $1,100 in the secondary market, the coupon will still be $70, but the yield is 6.4% ($70/$1,100) because you paid a premium for the bond. For a similar reason, if you buy it for $900, its yield will be 7.8% ($70/$900) because you bought the bond at a discount. If its current price equals its face value, the bond is said to be selling at par.

CHAPTER 15: INFLATION

INFLATION AND GAS PRICES COMPARED TO A BOND’S RATE AND YIELD

You are at home watching “Lilo and Stitch” on the Disney Channel with your kids on a Saturday morning when the doorbell rings. When you answer the door, there is a young man in jeans and a red golf shirt with a local gas station’s name printed on the left chest.

He quickly starts his pitch. “Sir, I am from the corner gas station and am going door to door because we made a mistake and you get to profit by buying a $150 gas debit card for $100.” Your immediate reaction of distaste for door-to-door salespeople is abruptly diverted by his statement.

“Say again?” you respond as you suddenly realize that you are in a white stained T-shirt and some flannel pants you got in college that you slept in last night.

“I said, I am from the corner gas station and am going door to door because we made a mistake and you get to profit by buying a $150 gas debit card for $100.”

“What is the catch?”

“No catch sir.” He replies. “The reason we are selling them for $100 is that our promotion starts at the beginning of next month and our printer misprinted them with next year’s date, so they will not be valid until next year at this time. It’s a great deal to you though. You get to make a 50% return on your investment. We thought since you live in the area and are coming to our store anyway, we would offer this to you as kind of a reward.”

Now, you may not be a mathematician, but that sounds like a pretty good deal! So you jump on it.

Of course, if you were a mathematician, or an economist, you would have thought about it a little more carefully. First of all, the price of the gas card represents a bond that will mature in one year. The “yield” is the $50 that that bond will return upon maturity. The X factor in determining if this is a good investment is simply this…

How many gallons of gas will $100 buy now, vs. how much will $150 buy next year?

Let’s assume this scenario is taking place in the early summer of 2005. (I guess they would be flannel boxers instead of pants then but follow along anyway!) Gas prices were right around $2 per gallon. $100 divided by $2 equals 50 gallons of gas. But by September of 2005, gas prices rose (inflation) to a national average of $3.07 per gallon. *

At that time $150 worth of gas would equal 48.86 gallons of gas ($150 divided by $3.07).

You would have LOST 1.14 gallons of gas! Not to mention tied up $100 worth of your money for one year! (GAS PRICE RESOURCE: Steve Stoft, Ph.D. economist https://zfacts.com)

CHAPTER 16: PRICE, RATE AND YIELD

So, being the numbers genius that you are, you explain to your savvy salesman that this is not a very good deal, because you are afraid that gas prices are going to rise too much over the next year (inflation). Now the bargaining begins. You are interested in buying a card though, so you offer him $80. After some back and forth, you strike a deal at $85. What happened? The PRICE of the card, or bond, decreased to $85 and the YIELD of the card, or bond, increased to $65.

Mortgage rates align with yield. As prices go down, yield (rates) goes up.?

Gas prices and other inflationary catalysts have always been the nemesis of mortgage rates. When bond prices go up, rates go down; when bond prices go down, rates go up.

To learn more about how the affluent manage their money visit www.affluentology.com or contact Todd Gehrke at [email protected]