How do the Fed Interest Rate Changes Really Affect Mortgage Rates?

Wondering why your mortgage payment hasn’t gone down even though the Fed has lowered rates? It is a common misconception that mortgage rates are directly tied to the federal funds rate. In fact, mortgages in general are not directly tied to the federal funds rate at all. Here are some quick pointers to keep in mind when considering how concerned you should or shouldn’t be about the decisions of the Federal Reserve Bank:

The market, not the federal funds rate, determines mortgage interest rates. Mortgage Backed Securities are bonds sold on public exchanges by Freddie Mac, Fannie Mae and the like. More than any other factor, the prices of these securities have the most impact upon mortgage rates.

Fixed rate mortgages are long term interest rates, while the fed funds rate is short term. Investors in fixed rate mortgages are much more concerned with factors such as inflation than they are with the short term federal funds rate. In some cases, mortgage rates will actually go up when the fed lowers the funds rate because the market fears future inflation may result from the cut.

Adjustable Rate Mortgages (ARMs) are tied to indexes, not the federal funds rate. The most common indexes are the London Inter Bank Offered Rate (LIBOR), the 11th District Cost of Funds Index (COFI), and the Constant Maturity Treasury (CMT). There are various factors that determine the movement of these various indexes. For example, the LIBOR is tied to interest rates in London, not the U.S.

Home Equity Lines of Credit (HELOC) are the mortgage type most closely tied to the fed funds rate. Most HELOCs are priced on some margin above the prime rate. While the prime rate is not the federal funds rate, it does track it almost exactly at 3 percent above.

In many cases the lowering of the federal funds eventually (albeit indirectly) makes its way to mortgages. However, this is far from a certainty and generally takes some time. As a holder of an ARM, or someone looking to get a new mortgage, don’t hold your breath expecting the looming fed rate decrease to save you money on your mortgage any time soon. In fact, it may cost you in the short term if investors in mortgage backed securities think more rate cuts will equal more inflation.