The Dilemma
As I get ready to head for bed, I can’t help but feel many of you out there are still wondering what may happen tomorrow when the Federal Reserve makes their next rate cut decision. The first thing you need to understand is that what the Fed decides does not directly impact mortgage rates.
When the Federal Reserve decides to make a rate change (or not), this only affects the Federal Funds Rate, which isn’t even consumer related. However, the Prime Rate is almost always the Fed Funds Rate plus 3%, so when they change the Fed Funds Rate, the Prime Rate changes with it.
Since Home Equity Lines of Credit are usually tied to the Prime Rate, those interest rates will likely change as well, depending on how your rate is computed which is spelled out in your loan documents.
Wait, didn’t I just say that what the Fed does doesn’t affect your mortgage? HELOCs are not your typical mortgage as they are more like a secured credit card, with the house being the collateral. They are also adjustable rate mortgages, adjusting every month in most cases. Typical mortgages, even adjustable rate mortgages, are not the same and are not tied to the Prime Rate.
Reality
Typical mortgage rates, such as those on your 30 year and 15 year mortgages are derived from mortgage backed securities (MBS or Mortgage Bonds). These are bonds traded like any other security and subject to market forces. Since inflation is the archenemy of bonds, what the Federal Reserve does with the Fed Funds Rate will impact the markets, and thus, mortgage rates as well.
Interestingly enough, mortgage rates almost always move opposite of what the Federal Reserve does with the Federal Funds Rate. That means if the Fed cuts their rate, mortgage rates will most likely rise, got it?
If you don’t get it, don’t worry. Here is a little background as to why…
When the Federal Reserve cuts the Federal Funds Rate, it allows for inflation to develop (like we have been seeing lately). Bonds don’t like inflation, so traders sell bonds, lowering the bonds’ price. When a bonds’ price drops, it’s “yield” rises and that is basically what mortgage rates are derived from, the yield of mortgage bonds. So, the Fed cuts rates and mortgage rates climb.
What Will Happen?
Now, for tomorrow’s decision, what will happen to mortgage rates. Since inflation has been climbing recently, the Federal Reserve showed decide to raise rates (long overdue in my opinion). If they are to do so, chances are mortgage rates would drop. I highly doubt our illustrious Federal Reserve would be so bold, so let’s assume they keep rates the same.
An unchanged rate will still allow inflation to grow, so if I were a trader, I would sell bonds even if the Fed leaves rates unchanged. That would mean that mortgage rates would likely climb. Heaven forbid the Federal Reserve would cut rates again (lock them up if they do), mortgage rates would likely go ballistic. Since mortgage bonds have been in a downtrend for a while now, chances are rates will continue to climb.
I hope that gave you some insight into the Fed’s decision and what happens to mortgage rates. For more on what drives mortgage rates, stay tuned to the Florida Mortgage Report and look for my book on the subject which I will be completing next month.
