QUESTION
I am the CFO of a mid-sized mortgage lender. We originate mortgages in 36 states. I am concerned about the impact that inflation has on mortgage banking. The tariffs are gradually driving up inflation, and economists predict a significant rise over time.
I am concerned about being prepared for inflation's effects on mortgage lending. I'm sure we can prepare for inflation. But my question is about the impact and the signs to look for. Thank you for considering this question.
What is the impact of inflation and tariffs on mortgage rates?
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ANSWER TO YOUR QUESTION
You ask a good question. Often, mortgage originators focus on interest rates, and with good reason. Inflation indirectly increases mortgage rates by prompting central banks to raise interest rates to slow the economy, which in turn leads to higher monthly payments for new and adjustable-rate mortgages (ARMs).
When rates rise, homebuyer affordability declines, and while fixed-rate borrowers are protected from future hikes, their new loans will have higher initial costs. For existing homeowners, high inflation can impact their decision to refinance, while low inflation may encourage them to lock in lower rates.
I think you are correct to tie tariffs to interest rates. Tariffs can negatively affect mortgage lending by raising interest rates and increasing monthly payments, thereby reducing housing affordability. This is because tariffs can increase inflation, prompting central banks to raise interest rates, and can also cause market instability and reduce demand for U.S. debt, further pushing Treasury yields and mortgage rates upward. Additionally, tariffs on construction materials raise home prices and can lead to more volatile application volumes and tighter underwriting standards for lenders.
CREDIT MARKETS
While many people monitor equity indices, I keep an eye on credit markets. In my view, the credit indices tell me what is really happening in the economy. Credit is a crucial component of the financial system, influencing everything from individual finances to broader economic trends and serving as an indicator of economic health. So, while others look at stocks and other equity instruments, I look at the primary, secondary, public, and private credit markets.
Prevailing interest rates are a key indicator of the health of the credit market. The level of investor demand also signals market conditions. And, the difference in interest rates between different types of bonds, like government bonds versus corporate bonds, can indicate economic risk. A widening spread can signal that investors are viewing corporate bonds as riskier, possibly foreshadowing a recession.
So, let's dig deeper into the impact of inflation on mortgage banking.
INFLATION
When inflation is high, the Federal Reserve may increase its benchmark interest rate to cool the economy. This directly leads to higher interest rates on new mortgages and can increase the monthly payments on existing ARMs. Higher interest rates and home prices make mortgages more expensive, reducing a borrower's purchasing power and forcing them to buy smaller or less expensive homes. High inflation might prompt some borrowers to take out an ARM with the expectation that rates will fall, enabling them to refinance later.
A fixed-rate mortgage offers some protection. Once a fixed-rate mortgage is secured, the interest rate will not change, even if inflation continues to rise. In a high-inflation environment, a fixed-rate mortgage taken out at a lower rate becomes more valuable compared to new mortgages with higher rates.
Thus,
refinancing becomes prevalent. If inflation is high and rates are rising,
homeowners with existing fixed-rate mortgages may be hesitant to refinance, as
new loans will have higher rates.
And when inflation is low and interest rates are lower, more homeowners may look to refinance their existing mortgages to lock in a better rate.
