Understanding Fed Rate Actions and Mortgage Loan Rates

Our firm frequently receives calls from confused borrowers who state, "I heard the Fed just lowered rates. What are mortgage rates down to?" On some of those occasions when we respond that mortgage interest rates have actually gone up, we are certain the next sound we hear will be a dial tone.

The Federal Reserve does not control mortgage loan rates--at least not directly. When the Fed lowers or raises rates, it is a reference to either the Federal Funds rate, or the Federal Discount Rate. A change in the Federal Funds rate, which receives the most media attention, means the Fed has adjusted the overnight rate that banks charge each other for reserves that are sitting in the Fed's vault. Because this "cost" of money has changed, banks then turn around and change the rates (usually the prime rate) they charge commercial borrowers. A change in the prime rate, therefore, affects commercial borrowing, home equity lines and some credit cards, to name a few. It does NOT change the conventional 15, 20 or 30 year fixed rates.

What does affect conventional mortgage loan rates are the yields on 10 year government bonds and the prices of mortgage backed bonds and securities, which are traded each day that the stock and bond markets are open. Usually, when the yields are going up, so are rates, and vice versa. Fannie Mae and Freddie Mac indices can be indicators of what direction--or pressure--is on mortgage loan rates. The yield on the 10 year government bond used to be an accurate indicator of rate direction. Recently, however, the mortgage crisis has compromised the integrity of mortgage backed securities and investors are apprehensive about buying them. This has skewed the ability to monitor rate direction by merely observing the direction of the 10 year bond yield, and therefore the Fannie Mae and Freddie Mac MBS indices are a more accurate indicator. What the public might not realize is that rates are priced each day that the markets are open and they are subject to change daily, sometimes more than once within a day.

The pricing of rates is a function of market and economic factors--not the least of which is investor demand--that plays a large role in what direction rates are going. Inflation is an enemy of mortgage rates, since bonds have fixed (coupon) rates and inflation erodes fixed rate returns on investment. The threat of recession, job reports, producer price indices, consumer sentiment, etc., etc., are also factors influencing the direction of rate movements.

So if you have a home equity line of credit, you can rejoice if the Fed lowers rates, or lament if the Fed raises them. What you must do, however, if you are contemplating a refinance, is to make calls and research quotes on conventional rates.