What the Fed rate cut means for your mortgage

On Tuesday, for the first time since 2003, the Federal Reserve cut their benchmark interest rate, the Federal Funds Rate, by 1/2% to 4.75%.  The Federal Funds Rate is the short term rate that banks charge to borrow money from each other.

There is a common misconception with consumers that when the Federal Reserve cuts the Fed Funds Rate, that mortgage rates fall the same amount.  This is simply not true.

Rates on home equity lines of credit, which are tied to the Prime rate, do fall by the same amount that the Fed Funds Rate falls, because the Prime rate almost always mirrors movement in the Federal Funds rate.  The Prime rate now stands at 7.75%, which means that a home equity loan tied to Prime (Prime + .5% for example), is now at 8.25% instead of 8.75% at the beginning of the week.

However, long term mortgage instruments are not tied to the Prime rate or to the Federal Funds Rate, but instead to mortgage-backed bonds which are traded on Wall Street.  When the Federal Reserve lowers their rate, it sends a signal to the markets that the economy will hopefully improve because of the rate cut.  This means that riskier investments such as stocks become more attractive to investors, and money tends to pour out of bonds and into stocks.  We have seen this the past 2 days as the stock market has once again approached 14,000. 

But a run up in the stock market means that the bond market is suffering.  As demand for bonds decreases, bond prices also go down, and yields up.  A bond at a higher yield, backed by a mortgage, will pass on a higher mortgage rate to the consumer.  Therefore, mortgage rates rise. 

We have seen this trend over the past 2 days, and it looks to be getting a bit worse before it gets better.  Mortgage rates are about 1/8% worse today then they were on Monday.  However, into late fall, if the economy continues to show signs of weakness, mortgage rates are likely to fall as investors return to the safe-haven of bonds and similar low-yield, low-risk securities.