Interest Rate 101
morHi gang,
You are reading this because you share the desire to peak into the future of mortgage rate direction and learn more about how mortgage rates are determined.
Yesterday's Fed meeting and the market's reaction to the rate cut and statement are great examples of how what happens to the Fed's Overnight Rate and long-term mortgage rates.
Let's delve in.
First, many people speak about "what the Fed did to rates" and it is important to clarify what they really did. They cut the interest rate on their Overnight Rate and the Discount Rate. These rates are the rates that the Fed charges big banks to borrow money. In turn, the big banks use the Overnight Rate as a benchmark for where they set their Prime Rate. The normal spread between the Overnight Rate and Prime Rate is 3 points. So, currently the Overnight Rate stand at 4.75% and that puts Prime at 7.75%.
Second, any homeowner with a Home Equity Line of Credit (HELOC) has a variable interest rate with some margin above or below Prime. This means that you will see immediate relief in lower interest being charged on any HELOC balances.
Third, and most importantly, what happens to long-term fixed mortgage rates (i.e. 15 year, 20 year, or 30 year terms) is dictated more by how the market thinks the Fed is managing INFLATION. Inflation is the Enemy #1 to any bond investor, including mortgage bonds, as rising inflation eats away at their investment. This is because a bond has a fixed interest payment schedule, returning interest to the investor at a fixed rate. If the value of the dollar, and the value of each fixed payment, is declining then the investment (the bond) falls in value. When bond values fall, yields rise. In your day-to-day world the yield is the interest rate.
So, here's the deal.
When the Fed cut their rates on Tuesday the U.S. dollar fell against a basket of foreign currencies. This means that it will take MORE U.S. dollars to purchase incoming goods produced in foreign lands. That is inflation. One of the big risks that the Fed exposes the economy to in easing (cutting rates) monetary policy is that they stoke up inflation.
This is the reason that we have not seen long-term mortgage rates improve dramatically on the Fed rate cuts. Yes, we have seen them moderate a touch lower but they still have not returned to the lows of the year, reached back January and again last March.
Do not expect that Fed rate cuts will guarantee lower mortgage rates ahead. Think about this, the Fed raised their Overnight Rate 17 consecutive times yet long-term mortgage rates barely budged.
Couple this knowledge with the knowledge of a very challenging real estate and mortgage underwriting marketplace and my general advice to everyone is to get your financing onto long-term fixed rates as soon as you can. If inflation heats up you will benefit by fixing your payment now. Those payments will become easier to make in the future.
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