Every time the Fed makes rate cuts we get a flood of calls because of the misconception of how exactly the fed funding rate and mortgage interest rates are related. So, here goes nothing.
What is the Fed Funding Rate?
The Fed Funding Rate according to Wiki is the interest rate at which private depository institutions (mostly banks) lend balances (federal funds) at the Federal Reserve to other depository institutions, usually overnight.[1] The rate is one open market operation that the Chairman of the Federal Reserve uses to regulate the supply of money in the U.S. economy.[2] The most recent change was made on January 22, 2008, in which the rate was lowered from 4.25% to 3.50%.
What is Prime Rate?
Prime Rate, according to Wiki. runs approximately 300 basis points (or 3 percentage points) above the federal funds rate, the interest rate that banks charge to each other for overnight loans made to fulfill reserve funding requirements. (The Federal funds rate plus a much smaller increment is frequently used for lending to the most creditworthy borrowers today, as is LIBOR, the London Interbank Offered Rate.) The Federal Open Market Committee (FOMC) meets eight times per year wherein they set a target for the federal funds rate. Other rates, including the Prime Rate, derive from this base rate.
Most business owners and homeowners are familiar with Prime Rate -- it's the rate upon which credit lines and home equity lines of credit are based. As the Fed Funding Rate increases, so does Prime Rate, and by association, so does the cost of short-term borrowing in our country.
How is this related to the rate on your mortgage loan?
As we just discussed the Fed Fund Rate does affect some mortgage products, such as home equity lines of credit. Now let’s look at if there is any relation to your typical 1st mortgage.
A typical first mortgage rate is not tied to the fed funds rate in the manor that the line of credit is. Contrary to popular belief, the most accurate indicator of which direction mortgage rates are headed is actually the mortgage backed securities market. Some loan officers would tell you to watch the US 10 - Year Treasury Note, which is in most cases is an ok indicator of the direction that rates are headed. However, those in the know would argue that the performance of the mortgage backed securities market is a much more accurate indicator of mortgage rate changes, especially if you are talking about intra-day changes.
So, on a day like today when the market is all over the place, and your loan officer says they are watching rates for you – ask them if they are watching the 10-Year Treasury or the mortgage backed securities market? Odds are you’ll throw them for a loop!
