The Fed Cuts Rates: Do You Really Know What Makes Mortgage Interest Rates Rise and Fall??

As everyone knows by now, The US Federal Reserve cut interest rates by 50 basis points today.  A half-point cut. 

This was a very aggressive move to try and avoid a recession that could be caused, in large part, by the housing market.

There wasn't a mortgage person or agent I spoke with today who didn't mention this to me.   It was like this was the greatest news in the world.  

Although it may end up being very good news, this decision may not mean anything to mortgage rates.  These comments made me think.

"Do you really know what makes mortgage interest rates rise and fall?"

I want you to take a moment to answer this question yourself before you read below. What do you think makes rates go up?

As professionals in this business, this is something we should all know.  Yet many don't. 

I work with agents who have been in the business for over 20 years who cannot answer this question properly. I have worked with many loan officers who also cannot answer this question.

First it helps to understand that there are many different types of mortgage interest rates.

There are Prime, T-bills, Treasury Notes, Treasury Bonds, Federal Funds Rate, Federal Discount Rate, Libor, 6-month CD rate, COFI, Fannie Mae Backed Security, and more.

Although I am probably missing one or two, each of these can be tied to your loan and each of these can rise and fall at different levels.

Actual mortgage interest-rate movements are based on the simple concept of supply and demand.

If the demand for credit or loans increases, so do interest rates. This is because there are more buyers. When there are more buyers, sellers can command a better price, i.e. higher rates.

If the demand for credit reduces, then so do interest rates. This is because there are more sellers. When there are more sellers, buyers can command a lower better price, i.e. lower rates.  This is why we have low interest rates today.  Even before today's announcement, rates have been low.

When the economy is expanding and growing, there is a higher demand for credit as more people look for more goods. As a result, rates move higher.

When the economy is slowing, people scale back, the demand for credit decreases, and so do interest rates.  Like today.

This leads to a very fundamental concept:

Inflation is also a factor. When the economy is improving, inflation results from prices of goods and services increasing. 

When the economy is strong, there is more demand for goods and services, so the producers of those goods and services can increase prices.

A strong economy therefore results in higher real-estate prices, higher rents on apartments and higher mortgage rates. Therefore, higher inflation is associated with a growing economy.

When the economy grows too strongly, the Federal Reserve increases interest rates to slow the econony down and reduce inflation.

However, once again, remember that although mortgage interest rates tend to move in the same direction as other interest rates, actual mortgage rates are also based on supply and demand for mortgages.

The supply/demand equation for mortgage rates may be different from the supply/demand equation for interest rates. This might sometimes result in mortgage rates moving differently from other rates.

The mortgage money behind your loan and mine comes from many sources.

Most of comes from investors through what is collectively known as the "capital markets." This is where investors interested in purchasing certain kinds of debt instruments, bonds, in this case, come to buy these items.

When you take out a mortgage, a bank, mortgage company or other mortgage originator is making you a loan at given interest rate.  The lender or mortgage originator usually sells that loan to an institution that packages it with other mortgages into what's known as a mortgage-backed security.

They then sell that security to investors. That investor earns a return by collecting the principal and interest payments that you and all the other mortgage borrowers make.

In order to get investors to buy those mortgage-backed securities, the sellers of these securities must pay rates of interest that are competitive with alternative interest-paying investments such as Treasury bonds.

These investors are mostly just individual people like you and me. And we all want the exact same thing: low payments on our debt, especially our mortgage, and high returns on our investments.

Contrary to popular myth, the Fed doesn't control mortgage rates.   Their most well-known policy tool, the Federal Funds rate, is the overnight rate which banks charge each other when another bank needs to borrow money to meet end-of-day reserve requirements. 

Banks need to keep a certain amount of reserves each and every night.   Sometimes they go under so they have to borrow from another bank to cover this.  The Federal Funds rate is the "suggested rate" for this short-term loan but banks can set their own number.  

That's what was dropped a half-point today as well as the Fed Discount Rate. 

Banks can also borrow money from the Fed to cover these reserves.  That's called the Discount rate.

Therefore, in reality, today's rate cut does not directly affect your business or mine at all, and therefore, on it's face, is nothing to get overly excited about.    Of course, there is often an ancillary effect.   

In today's credit crunch, there is little question that the Fed lowering the rate as dramatically as they did, should help free up some investment capital, which should provide more money for mortgage banks looking to sell loans, which, in turn, should loosen up mortgage guidelines a bit, which should help you and I sell more houses and close more loans. 

However, that doesn't mean mortgage rates will definitely go down.

A good way to keep a handle on the Fed is to remember that the Fed Funds rate is the shortest of short-term rates.  It's literally, an overnight loan. 

A fixed-rate mortgage is all the way at the other end of the scale, a loan that lasts as long as 30 years.    They are separate and unique.

You may have noticed in the past that sometimes the Fed cuts interest rates and then fixed mortgage rates actually rise as a result.

This is because if the Fed is taking steps to address economic weakness by lowering rates, that can sometimes means a return to faster growth and possible higher inflation is in the near term, which causes mortgage rates to then rise.

OK, so what moves mortgage rates?

Supply. Demand. Competition for money. Inflation. The Economy. Expectations. And you, of course.

So where are mortgage rates headed after today's news?

No one knows the answer with any certainty.    It was good news.   Most consumers don't understand what I wrote here and this move by the Fed also gives them confidence that now could be a great time to buy a house or refinance.   

Every bit helps today.   But if you are waiting for mortgage rates to lower because of today's news and you are now delaying a purchase or a refinance for another few weeks because of it, that could be a very big mistake.