The American financial system is under pressure. The Federal Government keeps lowering interest rates, yet mortgage interest rate predictions are still through the roof – what’s the story?And what will it mean for American home owners?

The relationship home owners need to grasp to understand interest rate predictions is the interplay between interest rates set by the Fed and mortgage interest rates charged by mortgage lenders.

Interest rates that are set by the Fed flow into the cost of funds to mortgage lenders. Financial institutions don’t own all the money they lend out as mortgages – they actually borrow 90% of what they lend out to home owners on the wholesale market.

When the Federal Reserve lowers interest rates, it lowers the borrowing costs for mortgage lenders. You would think, in that case, that interest rate predictions would fall. However, financial institutions may choose not to pass on the savings to mortgage holders.

The reason for this is not greed – there is adequate competition in the mortgage lending market to ensure that no bank or other lender can profit unfairly. The real reason is that being a mortgage lender is now a whole lot more risky, and perceived risk raises interest rates.

Financial institutions are everyone more interest to compensate for their losses on the few who will miss payments on their mortgages.Until the current housing market settles, risks for lenders will remain elevated, and interest rate predictions will continute to be high.

Of course, the government can’t lower interest rates continuously. The apparent interest rate (called the “nominal” rate) includes the rate of inflation. To calculate the “real” interest rate, we subtract the inflation rate from the nominal interest rate.

Today, when you do that, you get a negative number! It’s a real anomaly – nominal interest rates are lower than the inflation rate.

We all realise that this is a situation that surely cannot continue for any length of time. At some point, the Federal Reserve will have to raise interest rates to at least break-even levels, matching the rate of inflation. When it comes, the interest rate rise will immediately flow through into mortgage rates.

What we are saying is that it’s really only a matter of time, and not much time, before mortgage rates rise again.