Drop in Federal Funds Rate = Drop in Mortgage Rates?

Drop in Federal Funds Rate = Drop in Mortgage Rates?
by Hassan Nicholás


By now, we are all pretty accustomed to the bleek news that's reported daily about the failing real estate market. You might have even become desensitized to it and found other crises to worry about. So when we hear that the Fed announced another rate reduction, how should we respond? The little bit of optimism that we have left might tell us that we can expect a drop in mortgage rates, right? The short answer and probably most accurate is, we don't really know.

It's probably not the answer you wished for or what you've been reading from all those popular real estate discussion boards you're a member of. But my teachings in economics is begging me to resign to that fact that we can't predict the unpredictable...beyond predicting it's unpredictability (that's one for the books!).

So what does happen when the Fed reduces its rate?

For the sake of not boring you, I will keep this related to you and your interest in purchasing a home. When the Fed reduces the rate it is an attempt to stimulate the economy and encourage business. The Fund Rate is basically the rate of interest banks are charged for short-term loans.
Changes in the Fund Rate affect you because things such as credit cards, auto loans, ARMs and HELOCs (home equity lines of credit) are based off the Prime rate, which is derived from that rate of interest. So, when the Fed lowers the rate loans pinged to the Prime rate become cheaper. You will be more likely to break out the plastic in the department store, take out a car loan, or borrow money to expand your business - basically, you will be encouraged to spend and heat up the frozen credit market. Conversely, Certificates of Deposits and your online bank account at ING Direct will yield less.

Where does mortgage rates come in, you say? Since mortgage rates are long-term loans, they are less affected by changes in short-term rates. Mortgages are sold to investors as asset-backed debt called MBS (Mortgage Backed Securities). Basically, a piece of your mortgage is bought by a pool of investors, who then technically "own" your loan. The mortgage servicer, who you write your checks to, is the entity that "holds" the loan. The value of MBS are fixed, so when the future future value of MBS goes down the rate of interest to the homeowner will go up. However, this is not guaranteed. We have infact seen interest rates fall when the Fed made adjustments. [See where they're at now.] Historically, current mortgage rates are at a low, so instead of waiting for the housing market to bottom out or predict where mortgage rates are going, it might give you peace of mind (and save you money) to buy now...that is, of course, if you can afford it. But, we'll discuss whether or not now is the time to buy in another thread...