Friday, March 28, 2008

Mortgage Rates & Federal Funds Rates

Recently there has been a lot of press regarding the Federal Reserve lowering interest rates. Many people believe this action also lowers home mortgage rates, but the 30 year fixed mortgage interest rate is not directly tied to the Fed’s rate cuts.

First, a little background: Each day, banks are required by law to keep a certain amount of money in reserves, so that the next day they’ll have enough liquid assets to do business (e.g. make loans, fulfill withdrawal requests…).

At the end of the day banks do not always have their minimum reserve requirements in store. So the banks lend each other money overnight to meet their reserves. The interest rate at which the banks lend each other money is called the Federal Funds rate. This is the rate Federal Reserve Chairman Ben Bernanke has direct control over and has been cutting lately. Bernanke’s desired effect is to stimulate our economy by making money available more cheaply to banks.

Lending institutions can pass along the savings to consumers with some loans. For example, the Federal Funds rate correlates closely to the Prime Rate, which is the interest rate banks use to lend to their best customers. The interest rate for a Home Equity Line of Credit is typically set according to the Prime Rate.

The Fed cannot step in and control the pricing on the 30 year fixed rate mortgage. This rate is determined by the market demand for mortgage-backed securities and bonds. Typically when the bond market is doing well and the stock market is doing poorly the rate for a 30 year fixed mortgage is lower.

Simply put, a slowing economy equals lower mortgage interest rates. While a growing economy equals higher mortgage interest rates.

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