We hear mortgage professionals (mortgage brokers and mortgage lenders) misspeak all too often when attempting to educate the public on interest rates. These professionals hear “the Fed is raising rates”, and so they turn around a regurgitate what they hear, but they are telling the public that the Fed (aka US Federal Reserve) is raising the fixed rates most borrowers use when obtaining a home mortgage. This is completely incorrect, but sometimes they get lucky, like a broken clock is right 2 times per day. Let us dig deeper and learn the difference between the fed fund rate and the fixed rate mortgages we commonly use for our homes.
What does the fed in fact control? The Fed Fund Rate is an adjustable rate index. The index goes up and down as dictated by the fed. In times of crisis or recession, the fed will likely drop this index to stimulate an economy. How does this help an economy you might ask? If you earn 0.1% on your money in the bank, you (as in the mass consumers in an economy) are more likely to spend that money on goods, buy real estate, or invest/spend by other means. This is because there is no motivation to save at that low rate. An economy thrives on money being circulated. If money stops circulating, like when consumer confidence is down, then the economy declines. So its great for the fed to drop rates when needed, and in turn create the circulation of money. This fed controlled rate drop also drops the Adjustable Rate Mortgage rates (ARMs or Variable Rate).
Conversely, when the economy is booming, you want to slow or stop inflation by forcing the rates to rise at this time. Inflation happens when there is too much spending, and the sellers of goods are able to raise prices and profit more because more money is circulating. Unlike a recession or down turn, which is when the sellers of goods would drop prices to gain more clientele. So the fed plays an integral role in keeping the economy balanced during times of plenty as well as during times of scarcity.
The Fed Fund Rate is also the rate the Fed charges the banks to borrower money from the Fed to then turn around and lend to consumers. Then how does the bank earn money if they are paying interest to the fed on the money the bank borrows? This is where the “margin” comes into play.
An interest rate is made up of 2 parts; the index (like the fed fund rate or the LIBOR, London Interbank Offer Rate) plus the margin. Just think of profit margin when you see “margin”. Therefore, if the index is 1% and the margin for the bank is 2%, your adjustable rate mortgage (or variable rate) is 3%. When the fed comes out and says they are raising the rate by 0.5%, your rate then next month or year will be 0.5% higher, or 3.5% in this example.
Monthly adjusting vs Annually adjusting is the frequency with which your individual adjustable rate can fluctuate. If throughout a calendar year the fed raises rates 2 times by 0.5% each time, when your annually adjusting rate has its anniversary date, it will rise by 1%. The monthly is more volatile in that sense when rates are rising because it goes up every month, but more beneficial when rates are falling.
About the author:
Phil Stevenson is a Miami native and 1st generation Cuban American who has a degrees in Economics, International Relations, and Geography, which he completed after his 2 tours of duty with the US Army in Afghanistan and Iraq. He has been interviewed and quoted in Forbes as a mortgage expert 3 times since
2015, and has been flown to Washington DC twice by FINRA and NMLS since 2018 to be part of a Subject Matter Expert Panel to rewrite the National Mortgage Licensing Exam. Stevenson is on the Ethics Committee of the National Reverse Mortgage Lenders Association (NRMLA), and is a Certified Reverse Mortgage Professional (CRMP). He is the sole owner of PS Financial Services, LLC dba PS Mortgage Lending since 2012, and he is the direct mortgage lender while still maintaining the ability to broker to other lenders as needed for his clients. This unique hybrid model allows for more flexibility for his clients. His company motto; “we think outside the box, to help those who don’t fit in the box”!