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Federal Funds and Mortgage Interest Rate Correlation

Gina Pogol
LoanBiz Columnist

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Fed-watchers tend to fall into one of two camps--those who assert that reductions in the Federal Funds rate mean big savings to homeowners, and those who argue that the Fed influences mortgage rates about as much as it affects the weather. An analysis of historical data shows that there is some truth to both claims--it depends on what sort of loan the consumer has in mind. 

What Is the Federal Funds Rate?

Depository institutions like banks are required to maintain a certain level of deposits, called reserves, with the Federal Reserve Bank. This ensures that there is money to pay depositors when they want it. The Fed makes this money available to the institutions, which lend it out to each other overnight to cover fluctuating needs for cash. The line on the graph labeled "Federal Funds" represents the rate that banks and other institutions charge each other for these funds. So when the Federal Reserve "changes" its interest rate, what it's really doing is targeting a different rate and using its power in money markets to influence the banks--it doesn't have the power to dictate what the banks charge each other, only to influence the going rate.

Worth a Thousand Words: Picture the Future

Historical Interest Rates Comparison
Click to expand image.
When historical interest rate data is collected and graphed, it becomes obvious that there is a serious disconnect between the Fed's influence on short-term rates and the cost of long-term mortgage debt. In fact, Fed rate cuts may actually trigger increases in 30-year mortgage rates. This is because long-term rates are driven by bond markets, which reflect investors' expectation of future inflation. When the Fed cuts rates, more money is dumped into circulation to compete for a limited number of resources, thus driving up prices. In today's economy, the most in demand and limited resource is oil. Rising energy prices drive inflation, shake up the bond market, scare investors, and keep 30-year rates from falling.  

Take a Second Look: Home Equity Loans

So 30 year fixed rate mortgages probably aren't headed for the bargain bin any time soon, although they are still at near-historical lows. Those who remember paying 16% in 1982 know that 6% is still very cheap home financing. But where are the bargains? Surely the Fed isn't going to drop its rate unless it expects to benefit someone. And this second picture is as clear as the first--a graph of the Fed rate and the prime rate (which is the rate that banks charge their largest and most credit-worthy customers) shows these two rates parallel each other almost perfectly. And which mortgage product pricing is based on the prime rate? Second mortgages like home equity loans (HELOANs) and home equity lines of credit (HELOCs). So, home equity customers may be the big winners in the Federal Reserve rate game. And those who can't improve on their current mortgage might be able to secure a good rate on some emergency credit, funds for investment, or cash to consolidate more expensive debt. 

And Finally: Give ARMs a Break

The Fed's cut may also present a gift to homeowners anticipating adjustable rate mortgage (ARM) rate resets. Graphic illustration of historical ARM  interest rate data shows that both 5/1 and 1-year ARM rates follow the Federal Funds rates much more closely than longer term fixed rate mortgage rates do. In fact, many economists anticipate that a timely cut could offset impending rate increases somewhat for homeowners bracing for rate hikes, and even reduce the rates of borrowers whose rates have reset to higher levels in recent years.

Below is a table that compares the percentage change of the Federal funds rate, the prime rate and 30 year fixed-rate mortgage, and 5-1 and 1-1 ARM rates to further illustrate the ties between short term interest rates and long term interest rates.

Historical Interest Rates
Click to expand image.


In conclusion, an analysis of past mortgage and monetary market data has proven to be a fair predictor of the influence Fed rate changes have on home loan rates. And knowing how changes can affect personal situations may help borrowers and investors end up on the winning rather than the losing side.

 

Sources:

Bloomberg
Freddie Mac
Federal Reserve


About the Author
Gina Pogol writes for an online media company and specializes in finance and mortgage issues. She formerly worked as a systems consultant with Experian and a mortgage consultant with Centex. She has a BS in financial management from the University of Nevada.

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