There's been a lot of discussion this week about the Fed's rate cut, but it seems like many people are confused about the impact it's going to have. I asked my mortgage pro Perry what information he could give me, and I found out some interesting information.
How will the “Fed’s” rate cut effect home buyers?
In the short run… rates will likely go up for mortgage loans (except home equity loans). Yes, I said up. “But rates got cut, why would mortgage rates go up?” If you promise not to shoot the messenger I’ll explain. Let me start by clarifying some often confused terms and misconceived notions. The only rate that the Chairman of the Federal Reserve directly controls is the “Discount Rate” (see glossary below). He can influence but he has no direct control over mortgage rates! He also indirectly controls the “Fed Funds Rate” also called the “Overnight Rate” by setting a target for the rate. And since the Prime Rate is essentially the Fed Funds Rate plus 3% one could also say that he indirectly controls the Prime Rate.
A key concept to understand, one that many borrowers tend to get wrong is the fact that none of these rates I’ve mentioned (Prime, Discount, Fed Funds) are long term rates and Mortgage rates are every bit long term rates. Therefore, a change in the Fed Funds rate only influences mortgage rates it does not dictate them.
A half point reduction in the Feds Funds Rate does not translate to a half point reduction in Mortgage rates. In fact, though the two rates often trend in the same direction, they can actually move in opposite directions. I know it seems counter intuitive, but there are many other influences that effect long term rates and if those influences are getting more traction in raising mortgage rates than the Fed Funds Rate cut is getting in lowering them, the rate cut can be neutralized when it comes to moving mortgage rates. Sometimes long term rates actually trend in opposite directions with the Fed Funds Rate. Rates creeping upward despite Tuesday September 18th 2007’s half point reduction to the Fed Funds Rate is a classic example.
No one knows for sure where 30 year fixed rates will be 6 months or a year from now. Rates going up this week could have been a knee jerk reaction to inflationary fears spawned by the Fed stepping in and reducing the Overnight Rate. We could see rates come back a bit within the next few weeks if market speculators become less jittery about inflation.
The one thing that we know for sure is that though rates are not at the very bottom where they were a few years ago, they are still historically low. If you went to the gas pump tomorrow and paid 97 cents a gallon would you be pretty happy about that or would you think gee, my grandfather only paid 45 cents a gallon when he was a kid. So what! We may never see that again in our lifetimes. Mortgage rates are at 97 cents a gallon right now. Don’t put off buying the home you want hoping that rates dip “just a bit lower” because you may be waiting for 40 years. When rates are as low as they are now, the odds that they will go up vastly outweigh the odds that they will improve.
I’ll leave it with a positive note. Because most people’s home equity loans are tied to the prime rate and the prime rate is influenced by the recent rate cut, most people with a home equity line of credit will benefit by seeing their HELOC rate reduced by that same half point next billing cycle.
Remember: The Fed sets the Discount Rate and banks set the Federal Funds Rate and mortgage lenders set their individual Mortgage Rates based on numerous market conditions.
Market update: The central bank reduced the target rate for overnight lending between banks to 4.75 percent On September 18th 2007, saying in its statement that policy makers are trying to contain the housing slump while continuing to monitor inflation risks. The Fed also lowered the discount rate at which it makes direct loans to banks by another half-percentage point to 5.25 percent. The first half point cut in the discount rate came on August 17th and lowered it to 5.75 percent from its previous rate of 6.25%.
Glossary:
The Discount Rate (Currently 5.25%) is the interest rate set by the “Fed” or the Federal Open Market Committee (FOMC).This is the interest rate at which banks in the Federal Reserve System can borrow money from the Fed. However, once these banks have borrowed money from the Fed, they can lend it to other banks at whatever interest rate they want. This is where the Federal Funds Rate comes in.
The Federal Funds Rate (Currently 4.75%) is the rate banks charge each other as they lend money back and forth among each other. This rate is also referred to as the “Overnight Rate” because these loans are given in order to maintain their required reserves and often last for only one day. It is called the Federal Funds Rate because it is the rate banks charge to lend funds that they have received from the Federal government.
Note: The Fed uses the federal funds rate to control the supply of available funds, essentially controlling inflation. If the federal funds rate is low, banks are more likely to borrow from one another, using the reserves to grant more loans which in turn feeds the economy. If the Fed feels the need to slow things down, they will simply raise the federal funds rate, which will put the brakes on borrowing among banks.
The Prime Rate (Currently 7.75%) is the interest rate offered by commercial banks to its most valued customers. The prime rate is also the index for many mortgage programs, including HELOC’s (Home Equity Line Of Credit). The prime rate always adjusts according to how the Fed changes the discount rate.
In the short run… rates will likely go up for mortgage loans (except home equity loans). Yes, I said up. “But rates got cut, why would mortgage rates go up?” If you promise not to shoot the messenger I’ll explain. Let me start by clarifying some often confused terms and misconceived notions. The only rate that the Chairman of the Federal Reserve directly controls is the “Discount Rate” (see glossary below). He can influence but he has no direct control over mortgage rates! He also indirectly controls the “Fed Funds Rate” also called the “Overnight Rate” by setting a target for the rate. And since the Prime Rate is essentially the Fed Funds Rate plus 3% one could also say that he indirectly controls the Prime Rate.
A key concept to understand, one that many borrowers tend to get wrong is the fact that none of these rates I’ve mentioned (Prime, Discount, Fed Funds) are long term rates and Mortgage rates are every bit long term rates. Therefore, a change in the Fed Funds rate only influences mortgage rates it does not dictate them.
A half point reduction in the Feds Funds Rate does not translate to a half point reduction in Mortgage rates. In fact, though the two rates often trend in the same direction, they can actually move in opposite directions. I know it seems counter intuitive, but there are many other influences that effect long term rates and if those influences are getting more traction in raising mortgage rates than the Fed Funds Rate cut is getting in lowering them, the rate cut can be neutralized when it comes to moving mortgage rates. Sometimes long term rates actually trend in opposite directions with the Fed Funds Rate. Rates creeping upward despite Tuesday September 18th 2007’s half point reduction to the Fed Funds Rate is a classic example.
No one knows for sure where 30 year fixed rates will be 6 months or a year from now. Rates going up this week could have been a knee jerk reaction to inflationary fears spawned by the Fed stepping in and reducing the Overnight Rate. We could see rates come back a bit within the next few weeks if market speculators become less jittery about inflation.
The one thing that we know for sure is that though rates are not at the very bottom where they were a few years ago, they are still historically low. If you went to the gas pump tomorrow and paid 97 cents a gallon would you be pretty happy about that or would you think gee, my grandfather only paid 45 cents a gallon when he was a kid. So what! We may never see that again in our lifetimes. Mortgage rates are at 97 cents a gallon right now. Don’t put off buying the home you want hoping that rates dip “just a bit lower” because you may be waiting for 40 years. When rates are as low as they are now, the odds that they will go up vastly outweigh the odds that they will improve.
I’ll leave it with a positive note. Because most people’s home equity loans are tied to the prime rate and the prime rate is influenced by the recent rate cut, most people with a home equity line of credit will benefit by seeing their HELOC rate reduced by that same half point next billing cycle.
Remember: The Fed sets the Discount Rate and banks set the Federal Funds Rate and mortgage lenders set their individual Mortgage Rates based on numerous market conditions.
Market update: The central bank reduced the target rate for overnight lending between banks to 4.75 percent On September 18th 2007, saying in its statement that policy makers are trying to contain the housing slump while continuing to monitor inflation risks. The Fed also lowered the discount rate at which it makes direct loans to banks by another half-percentage point to 5.25 percent. The first half point cut in the discount rate came on August 17th and lowered it to 5.75 percent from its previous rate of 6.25%.
Glossary:
The Discount Rate (Currently 5.25%) is the interest rate set by the “Fed” or the Federal Open Market Committee (FOMC).This is the interest rate at which banks in the Federal Reserve System can borrow money from the Fed. However, once these banks have borrowed money from the Fed, they can lend it to other banks at whatever interest rate they want. This is where the Federal Funds Rate comes in.
The Federal Funds Rate (Currently 4.75%) is the rate banks charge each other as they lend money back and forth among each other. This rate is also referred to as the “Overnight Rate” because these loans are given in order to maintain their required reserves and often last for only one day. It is called the Federal Funds Rate because it is the rate banks charge to lend funds that they have received from the Federal government.
Note: The Fed uses the federal funds rate to control the supply of available funds, essentially controlling inflation. If the federal funds rate is low, banks are more likely to borrow from one another, using the reserves to grant more loans which in turn feeds the economy. If the Fed feels the need to slow things down, they will simply raise the federal funds rate, which will put the brakes on borrowing among banks.
The Prime Rate (Currently 7.75%) is the interest rate offered by commercial banks to its most valued customers. The prime rate is also the index for many mortgage programs, including HELOC’s (Home Equity Line Of Credit). The prime rate always adjusts according to how the Fed changes the discount rate.
PERRY (Timothy Perry)
Home Mortgage Consultant
Wells Fargo Home Mortgage
866258-8363 Office
866711-6377 Fax
timothy.perry@wellsfargo.com
1 comment:
There's been a lot of discussion this week about the Fed's rate cut, but it seems like many people are confused about the impact it's going to have.
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