Most of us know that mortgage rates rise and fall, but we do not have much of an idea about what causes that to happen.
While there are many factors that contribute to mortgage interest rates, the actions of the Federal Reserve can directly impact mortgages and their respective interest rates.
Read on to learn more about why your mortgage rate could be higher or lower based on what the Fed is doing.
What Is the Federal Reserve?
Before we dive into the Fed’s impact on interest rates and mortgages, let’s take a moment to review what the Federal Reserve actually is. The Federal Reserve is the central bank of the United States. It’s not controlled by the government, but it does have the task of managing the country’s currency and monetary policy, as well as keeping the economy stable.
These responsibilities mean the Federal Reserve impacts nearly every facet of your economic life. They influence credit card interest rates and business loan rates. They can also control how much you have to pay for everyday items, since they are charged with keeping a handle on inflation.
What Are Interest Rates?
Many of us hear about interest rates for all sorts of things. We have interest rates on our credit cards, student loans, car loans, mortgages, and savings accounts. But what are interest rates, and how do they work?
Interest rates are effectively fees that the bank charges or pays you for the lending of money. When you pay interest on a car note or a mortgage, you’re paying the bank a small percentage of the loan amount for the privilege of borrowing their money. The interest you earn on savings accounts is payment from the bank for the privilege of using your money to finance other transactions.
Federal Funds Rate
When you hear about the Fed cutting interest rates, however, that refers to the interest on overnight reserve loans. These are loans banks give to each other overnight to meet mandated reserve levels. Borrowing and lending banks negotiate their interest rates individually, with the Federal Reserve as a guide.
The rate indices shown here are provided by the Optimal Blue Mortgage Market Indices (OBMMI) and are calculated from actual locked rates with consumers across more than one-third of all mortgage transactions closed nationwide. They do not reflect APR (Annual Percentage Rate) offered by Choice Home Mortgage. Your actual rate and loan terms will be determined by your creditworthiness and other factors.
The Federal Reserve recommends a certain interest rate for these loans, and in general, that recommendation is followed. The Fed may also take actions to help banks meet these federal funds rate goals. And while the Fed is not directly cutting your interest rates, these rate cuts can impact your finances.
Tools of Monetary Policy
Interest rates on overnight reserve loans are only one of a variety of tools of monetary policy the Fed has at its disposal. In essence, these tools are used to meet the Fed’s stated goals. They use these tools to keep prices stable and economic growth sustainable over the long term.
For example, when the Fed lowers overnight reserve loan interest rates, it allows banks to lower their interest rates for loans to their customers. These lower interest rates may inspire customers to take out more or bigger loans, funneling more money back into the economy. The Fed can use interest rate adjustments like this the same way you might turn on and off a tap – raise rates a little when economic growth is moving too fast and lower it a little when things need a boost.
Why the Fed Raises Interest Rates
It may sound strange that the Federal Reserve would want to slow down economic growth. After all, more money moving through the economy seems like a good thing, right? But if the economy grows too much too fast, it can become unsustainable and lead to a market crash.
On the flip side, keeping interest rates too high can slow down economic growth. Consumers wait to buy houses, keep driving old cars, and avoid large purchases. The Fed plays a delicate balancing game with how much economic growth they encourage at one time.
Open Market Operations
One of the ways the Fed can make sure banks hit the target interest rates is a tool called open market operations. In simplest terms, this is when the Federal Reserve buys and sells government bonds as a way to funnel money into or out of the economy. A bond is a note you can buy from a government with a promise that, when the bond reaches maturity, you can sell the bond back for face value, plus the interest that has accrued on it in the meantime.
When the Fed wants to see more economic activity and lower interest rates, it buys back bond notes. This introduces more money into the system and encourages banks to drop their interest rates for overnight reserve loans. If they need to tighten things up a little, they sell more bonds, drawing more money out of the system.
Other Monetary Policy Tools
The Fed also has several other tools at its disposal to make sure bank interest rates hit targeted goals. For one thing, they can tweak bank reserve requirements to make them higher or lower. A reserve requirement is how much money a bank must have in the vault at night in order to guarantee the funds in their accounts.
The Fed can also adjust the terms on which it lends to banks to make them more or less stringent. It can adjust the interest rate it pays on the bank reserves it has on deposit. All of these adjustments effectively control the flow of money in and out of banks and the economy.
The Ripple Effect
So why should it matter to you if the Fed is changing the amount of money your bank has to have in its vault at night? Let’s say you have a checking account and a retirement savings account with Yourtown Bank. The fed lowers the amount of money Yourtown Bank has to have in reserve every night and lowers the interest rate goals for those reserve loans from other banks.
Now Yourtown Bank has a little more breathing room to work with the money they have. In the interest of keeping their customers happy, they decide to lower their own loan interest rates and increase the interest rates on that retirement savings account you have with them. Not only are you making more money towards your retirement now, but you can also buy a house at a lower mortgage interest rate.
How Mortgage Rates and Fed Rates Interact
The relationship between mortgage rates and the Fed interest rates is complex to say the least. In many cases, the system works as we’ve discussed. The Fed raises or lowers rates, banks follow suit, and you see mortgage rates fluctuate accordingly.
But banking doesn’t operate in a vacuum, and people are constantly speculating whether Fed rates will go one way or another. Certain high-level officials will let hints slip in public speeches, and banks take notice and adjust their mortgage rates based on that speculation. The Fed interest rates may then follow that adjustment or even adjust the opposite way to compensate for it if it moves too far beyond what they want.
Current Federal Funds Rate
You may not be surprised to learn that the COVID-19 pandemic has had a major impact on the Fed interest rates. On March 15 of this year, the Fed agreed to drop rates a full percentage point as an emergency response to the pandemic. The hope with this move was to stimulate a faltering economy and get more money moving through the system.
As of this writing, federal fund rates are sitting around a target of 0 to 0.25 percent. The Fed plans to keep these rates near zero until they are certain the economy has fully stabilized. This may mean lower interest rates for quite a while, since scientists are predicting a second wave of the coronavirus to hit sometime this fall.
How Financing Works
So now that we understand a little about how the Fed’s decisions impact your mortgage rate, let’s talk some about how mortgage financing works. Most of us think of a mortgage as a loan that we use to pay off a house. But in fact, a mortgage is a specific agreement that allows your lender to take possession of your home if you fail to pay off your mortgage in the specified time.
How much interest you have to pay on your mortgage depends on a few factors. The bank will look at things like your debt to income ratio, your recent income, and, of course, your credit score. This last item is a rating of how much you can be relied upon to pay your debts on time.
If you have a very high credit score and excellent credentials in the other areas that banks evaluate, you may be eligible for a prime lending rate. Unlike normal mortgage rates, this rate is directly linked to the Fed’s target rate for bank reserve loans. In general, you’ll pay 3 percent more for a prime mortgage rate than the Federal Reserve target rate.
Right now, if you qualify for a prime lending rate, you’ll be paying very close to a flat 3 percent. Over the lifetime of a loan, this could save you thousands of dollars, especially if you have a fixed-rate mortgage.
How Much Higher Rates Impact Mortgages
So let’s say you buy a house for $500,000 with a 3 percent fixed interest rate next month. In July 2018, that rate was around 4.8 percent. How much difference could a couple of percentage points really make?
If you pay $2,623 every month on your half-million-dollar home for thirty years, you’ll wind up paying nearly a million dollars for the house by the time you get done paying off the interest. But if you get that interest rate locked in at 3 percent, over the lifetime of the loan, you’ll pay just $758,887. That means you’ll save more than $185,000 by buying now, and you’ll be able to buy a cute vacation cottage with the money you saved.
Lower Interest Rates, Higher Prices?
It may seem counter intuitive at first, but lower interest rates could actually mean higher house prices. A lot of people will be looking at that $185,000 figure and doing the same math you are. This means there will be a lot of people trying to buy houses while rates are so low (which is part of the Fed’s goal).
An influx of demand for houses makes the real estate market a seller’s market. People selling houses will have an easier time moving them, meaning they can raise prices.
The Current Housing Market
If you’re considering moving houses or refinancing your mortgage, this is the perfect time to do it. You may have an easier time moving your home than usual since buyers are so much more motivated to snag these low interest rates. You can also set the price a little higher, get a little more from the sale, and lock in your own lower interest rate.
However, it is important to remember the impact COVID-19 is having on the market. While it is true that interest rates are at historic lows, people are hesitant to go tour a bunch of houses due to the risk of exposure. If you can set up virtual tours of your house, you may have an easier time moving it.
Learn More About How Interest Rates Impact Mortgages
Understanding how Federal Reserve interest rates impact mortgages can be tricky to say the least. Just remember, when the bank is being charged higher rates, they’re likely to pass those expenses on to you, and vice versa. And if you’re planning on buying or selling a house soon, it’s a good idea to act quickly and lock in these low mortgage rates.
If you’d like to get help in managing your new mortgage, check out the rest of our site at Choice Home Mortgage. We provide flexible mortgage products, an easy process, and quick service to make your mortgage or refinance as easy as possible. Apply now and start saving for your future today.