If you watch the news at all, you probably have noticed that interest rates are trending upward. Depending on the news you prefer, you may either be hearing doomsday stories of another impending credit melt-down, or you may be hearing positive outlooks based on rosy economic forecasts.However, no matter the spin your financial news puts on interest rates, home buyers sometimes find it confusing how the broader interest rate market, and particularly the actions of Federal Reserve (or “The Fed” as it’s usually dubbed), play into what you will pay to buy a home.
We could write a whole dissertation on economic policy and the affects downstream, but we’ll try to keep this overview short and sweet. If you have questions, you can always reach out to us or your mortgage broker.
The Federal Reserve
The Fed is a governing body charged with managing monetary policy. It was put into place in 1913 under President Woodrow Wilson, but it’s powers greatly expanded in the aftermath of the Great Depression, in an effort to ensure that the US would never again experience such a devastating financial meltdown. There is obviously much more complexity to the evolution of the Federal Reserve, but the long and short is that they have a number of monetary tools to that can either help stimulate a flagging economy or temper an overheating one. They also ensure that banks keep a specific amount of cash in reserve (called the Federal Reserve Requirement), so that they don’t lend it all out and leave their depositors short.
The tool that you most often hear about is the “Fed Funds Rate”. Banks borrow from each other routinely, in order to meet their Federal Reserve obligation. The Fed Funds rate is the interest rate they charge each other to borrow those funds overnight. The Federal Reserve Open Market Committee meets 8 times per year, and at this meeting they will adjust the rate up or down, or keep it the same.
The Fed Funds rate has been historically low since 2008, when the credit meltdown brought the economy to a near standstill. This is why people usually associate it with the historically low mortgage interest rates that homeowners have enjoyed for the last several years. However, the Fed Funds rate has its greatest impact on short term lending instruments like credit cards, auto loans, etc.
The other monetary instruments at the Fed’s disposal have a greater impact on mortgage interest than the Fed Funds rate. The Fed engages in the buying and selling of Treasuries, and this activity either releases more credit to consumers (expansion) or removes it (contraction). During periods of contraction, the supply and demand for Treasuries will cause interest rates to rise. When there is less credit available, banks may become more selective in who they lend to, which also impacts the minimum credit scores and other selection criteria used to approve or reject credit applicants. During periods of expansion, there is more credit available, which lowers interest rates and loosens the criteria banks use to qualify borrowers.
The Broader Interest Rate Market
As mentioned above, the Federal Reserve has several tools in its arsenal for controlling the availability of credit. Mortgage rates are most closely tied to the 10-year Treasury. However, there are other factors that impact the interest rates of Treasuries, other than Fed activities. Remember, Treasuries are direct debt obligations of the US government. Other countries invest in our Treasuries, as well as individual investors, businesses, and mutual funds/pension plans. The value of these Treasuries is directly tied to the confidence in our government’s ability to meet these obligations (Treasuries are like promissory notes, in which the government pays interest, and promises to pay the face value to the holder at a later date). So our overall economic health, and the confidence investors have in our economy, directly impacts Treasuries and their interest rates.
So how does all this impact mortgage interest? Well, as previously mentioned, mortgages are most closely tied to the 10-year Treasury. There are a few mortgage lenders that may base their interest rates in LIBOR, which is the London Interbank Offer Rate, which is an international equivalent to the Fed Funds Rate. Regardless, mortgage lenders will then tack on a few basis points to the base rate, which will vary depending on the credit worthiness of the borrower. They will charge a higher interest to those with bruised credit, because the banks are taking a greater risk in extending credit to the borrower. Borrowers with excellent credit receive the best rates.
The mortgage interest rate is a critical piece of the home-buying puzzle. A one-percent change in the interest rate can add hundreds of dollars to the monthly payment, depending on the mortgage loan amount, which can potentially shut some buyers out of the market. Over the 30-year life of a typical mortgage loan, this can add tens or hundreds of thousands of dollars to the overall cost of the home.
Mortgage rates can also impact other areas of the real estate market. As interest rates rise, there may be fewer buyers out looking for homes. This means that sellers have to compete for a limited number of buyers, creating a “buyers’ market”. Sellers may be forced to lower the price of their homes or give more concessions in the contract process than they would when more buyers are flooding the market.
Mortgage lending is a complex process. You want a lender that will answer all your questions and help you through the process for the best possible outcome. Through our network, we can help you find high quality, ethical, and creative lenders who are ready to help you make your dream come true. When it comes to buying or selling your home, we are here to help answer any questions and guide you through a better understanding. Please do not hesitate to contact us at firstname.lastname@example.org or phone us at 202.800.0800.
Tags: Tim Pierson, Northern Virginia, Interest Rates, Federal Reserve, Mortgage Lending, Mortgage Interest, Credit