Dr. Ben Bernake and the Federal Reserve have cut short-term interest rates for the last two consecutive months by a total of .75% in an effort to prevent the U.S. economy from slipping into a looming recession. Since most consumers do not understand how short-term interest rates actually impact their ability to borrow money, these rate cuts often create a common misconception that a decrease in the Federal Funds Rate translates to an equal drop in mortgage interest rates when these cuts often cause the latter to rise.
There are two primary interest rates controlled by the Federal Reserve that dictate the overall cost of borrowing money on a short-term basis: the Discount Rate and the Federal Funds Rate. The Discount Rate is the interest rate the Federal Reserve Bank charges member banks when these institutions borrow money from the government. The terms of these loans are usually no longer than 30 days and generally do not have a direct impact on the consumer. The Federal Funds Rate is the interest rate that commercial banking institutions charge each other over night for the use of Federal funds to meet their individual reserve requirements. This interest rate tends to impact the individual consumer and the economy as a whole over time more directly.
Mortgage interest rates, on the other hand, are determined by the trading price of mortgage-backed securities and fluctuate based on the performance of the bond market. The 30 year fixed rate mortgage tracks the yield on the 10 year Treasury note and usually runs about two percentage points higher than the 10 year Treasury yield on any given day. In accordance with basic rules of supply and demand, when investors purchase mortgage bonds the price of the securities increase, causing yields and interest rates to drop. Conversely, when investor appetite for mortgage-backed securities decreases, bond yields and interest rates rise as the bond prices drop.
Over the last few months bonds have been favorable investments in light of the credit crisis caused by bad loans, a weak labor market, and a slow housing market, and as a result these soft economic indicators long-term mortgage rates have seen steady declines. Since the Federal Reserve leverages rate cuts to stimulate economic growth, there is a good possibility that investors will abandon conservative bonds and seek out more aggressive variable rate investments (i.e. stocks) as soon as recession fears pass, causing bond prices to drop and mortgage interest rates to rise.
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Damon Chavez is the co-founder of Colorado House Finders, a full-service online resource for real estate in Colorado. Damon's dedication to customer service and knowledge of the Colorado real estate market make him the smart choice when thinking about a move to Colorado.