Falling oil prices is one reason why mortgage rates are dropping for the first time in 6 days.

Oil is off $9 per barrel from last week, a shift that correlates to $0.23 per gallon of unleaded gas, roughly.

This drop is good news for both home buyers and “rate shoppers” — high gas prices is partly to blame for rising mortgage rates this week.

The connection between oil prices and mortgage rates is not necessarily clear, but it goes like this:

• High oil prices are linked to inflation
• Inflation devalues the U.S. dollar
• Mortgage bond repayments are made in U.S. dollars

Therefore, inflation devalues the payments made on mortgage bonds and investors typically avoid products with decreasing returns.

So, as demand for mortgage bonds fall, prices fall, too. This is basic Supply and Demand and many people “get” how that relationship works. But what is not so well known is that when the price of a bond falls, its corresponding interest rate goes up.

The reverse is true, too, and that’s what we’re seeing today. Because oil prices are falling, it’s reducing one of the many inflationary pressures on the economy and mortgage bonds are suddenly more attractive to investors.

Higher demand means higher prices and lower yields. Mortgages rates are benefiting from the action this morning — they’re down about 0.125 percent across the board.

Mortgage financier Fannie Mae is toughening its mortgage application decision-making process effective Monday, June 2, 2008.

The new guidelines will force many Americans to face higher mortgage rates, higher loan fees, or to be shut out from “prime” mortgage rates altogether.

The new “mortgage rules” include the following changes:

1. Higher income levels required for basic approvals
2. Interest only loans are now considered high-risk
3. Condos are now considered high-risk
4. 60-day mortgage lates within 6 months are a major red flag

Not all of the changes are for the worse, though.

In the new guidelines, self-employed borrowers will no longer be viewed as more risky than a W-2 employee. This will help small business owners and commission salespeople get more mortgage approvals than in the past.

Fannie Mae agreed to honor all mortgage approvals granted prior to its changes, so if you’ve been putting off that pre-approval, consider talking to your loan officer before the weekend starts.

Your mortgage approval will be much more lenient today than if you wait until Monday.

The monthly Case-Shiller Housing Price Index is a popular and often-quoted measurement of the housing market’s health. The chart above is sourced from its report published yesterday.

In 18 of the 20 largest metropolitan areas, home values declined at a slower pace than in the previously measured month. The report also showed that national home prices are down 14.4 percent from March 2007.

Unfortunately, it’s the more sensation “14.4″ figure that newspapers chose to report this morning. If you never went further than the headline, you’d miss a key piece of analysis.

Comparing today’s market to last year’s market is a lot less valuable than comparing it to last month’s market. That’s a better way to analyze the market’s health.

If we look beyond the headline and examine the data behind it, we see that housing may still be sagging in some areas, but it’s not sagging nearly as much as it used to.

High oil prices are derailing the mortgage market this week, taking an almost-vertical path higher.

Since mid-February, prices are up by 50 percent.

Rising oil prices can be a threat the U.S. economy because with every extra dollar that Americans pay to energy companies, there is less money available for every other company that makes up our national economy.

Strangely, it comes at a time when the “other” companies need it the most — their costs of operating are rising, too.

So, businesses are faced with a tough choice and both option prove poor for mortgage rates.

1. Keep prices level and suffer smaller margins (and profits)
2. Pass higher costs onto consumers in the form of higher prices

If profits suffer, job cuts and a weak corporate spending can undermine an economic recovery. If higher costs are passed on, it leads to inflation and that devalues the U.S. dollar and mortgage bonds.

This is why mortgage rates have spiked along with oil prices this week. And, when oil prices level off a bit, we can expect that mortgage rates will, too.

Crude oil is up 1.8 percent this morning.