So, the Federal Reserve Bank lowered interest rates to a range of 0% to 0.25%. Why aren’t mortgage rates following? Well, time to dust off that old college economics book. Let’s answer that by following the chain of economic reactions to the Fed’s actions and the principals of supply and demand.
How is the benchmark federal funds rate related to mortgage rates?
The rate that the Fed cut is the benchmark federal funds rate.
This is the short-term interest rate banks charge other banks for overnight lending and borrowing. So, bank to bank loan deals.
The Fed dropped this rate on March 15 for the second time in 2020 in response to the economic disruption caused by the Coronavirus. When the target federal funds rate decreases, banks typically follow by lowering their prime interest rates. The prime interest rate is used to set variable interest rates.
So, that new credit card application you just got in the mail might have a lower rate than your current credit card. Lowering the prime rate will cause other consumer interest rates tied to the prime rate to decrease as well. Businesses will have access to short term loans with lower interest rates to help with cash flow needs.
How does the federal funds rate and prime rate affect mortgage rates?
Mortgage rates are different from other consumer interest rates. Generally, mortgages rates don’t track the Fed’s movements. Mortgage rates are long-term loans, versus the short term variable rate we talked about earlier. So mortgage rates will go up or down depending on long term bond yields. The bond market exerts more influence over mortgage rates, not the Fed.
When the stock market falls, investors flee to government bonds for safety and stability. When the demand for bonds goes up, the price of bonds goes up. Bond prices and yield/interest rates have an inverse relationship. So, when bond prices go up, interest rates go down. Mortgage bonds are the same. When demand for mortgage bonds goes up, mortgage rates go down.
When will mortgage rates drop?
Early in March, mortgage rates dropped because the demand for long-term mortgage bonds was high. In response to low mortgage rates, the market was flooded by consumers looking to refinance. The supply of mortgage bonds increased and the demand for mortgage bonds dropped. Within a week or two, mortgage rates rose quickly.
The Fed is using other tools in their arsenal to cushion the economy, including buying Treasuries and mortgage-backed securities. As the demand for mortgage bonds grows, mortgage rates will come down again. However, consumers aren’t likely to see 0% mortgage rates. Mortgage bonds are considered riskier than government bonds. Interest rates are higher to compensate for the additional risk banks take in making the loans.
If you are looking to refinance your current mortgage or buy a house, keep your eyes on the rates. Be ready to go when rates dip. Be aware that you won’t be the only one refinancing when rates are attractive. Mortgage brokers will be busy and lock-in periods of 60 to 90 days (or even longer) are becoming more common.
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