Last time we covered the Fed Funds Rate in Part 2. Now on to the final component.
Prime Rate: The Prime Rate is the rate banks charge their best customers for higher risk loans. i.e. Home Equity Lines of Credit, construction loans, credit cards, etc. The prime rate has nothing to do with first mortgage rates. For example first mortgage rates for a 30 year fixed are now in the 6.xx% range and prime is 8.25%. Now, prime is determined by taking the Fed Funds Rate and adding 3% to it. So current Fed Funds is 5.25%. Add the 3% and you get 8.25%. As of this writing that is exactly what the Prime Rate is.
So, how to prove the Fed doesn't control first mortgage rates?
Between July of 2004 and June of 2006 the Fed raised the Fed Funds rate (and thus the Prime Rate) 17 times. This meant an increase in the Prime Rate from 4% to 8.25%. Now, if the Fed controlled your standard 30 year 1st mortgage what would you expect mortgage rates to do over this time? Go up right? Well they didn't! In fact first mortgage rates went down! The reasons for this and an explanation of what actually controls first mortgage interest rates is a topic for another time.
So the next time you hear news about the Fed and lowering interest rates, you can comment correctly on the true impact this will have on your cost of borrowing.
I hope this helps,
Dan Dowling
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