Fed Rate Cut - Why Didn't Mortgage Rates Fall Much?

The Fed's emergency three-quarters of a point rate cut didn't have much impact on mortgage rates...or did it? Well, it did and it didn't (don't you love answers like that)? The bottom line is that the Fed Funds rate certainly impacts mortgage rates, but sometimes indirectly, and surprisingly, sometimes they can move in opposite directions! This is a very high level and over-simplified discussion of the whys and hows -- it's tough to fit this in to one post though, and I'm not a mortgage banker, so bear with me, and feel free to contact me directly if you want to discuss more. Here we go:

The Fed Funds Rate is the overnight borrowing rate between banks. Banks are required to have certain reserve funds at the Fed each night to cover their deposits (remember reading about the Depression and runs on banks?) Sometimes banks don't have the funds so they borrow from other banks who have excess funds. The rate is an important policy tool of the Fed--it helps keep the balance of economic growth vs inflation in check. That's the key trade-off that the rate helps control--if rates are too low, we'll get inflation. If rates are too high, it prohibits growth.

The FFR is a very short term rate (overnight), whereas mortgage rates are more aligned with longer term instruments like bonds. After all, a buyer is theoretically borrowing money for 30 years (the length of a mortgage, though the lenders all know that most borrowers sell or refinance long before that time.) Bond yields, which impact 30 year mortgages, are tied to long term investor market expectations.

So which loans does the FFR impact?

30 year fixed -- Not directly impacted, though they often move in tandem because of shared expectations about long term growth of the economy. But if the FFR drops too low and investors get too worried that it will result in inflation, then mortgage rates can actually move in the opposite direction.

ARM loans -- These are generally tied to short term (1 year) treasuries, and so likely are impacted by rate cuts, but only if it varies from what was "expected" (see more below).

HELOCS -- These are generally tied to the prime rate, which moves in step with the Federal Reserve.

Subprimes -- Depends what index it's tied to, but they are often tied to LIBOR. LIBOR rates have been falling this month.

How markets move after FFR changes depends on expectations; the Fed meets on a regular schedule and many pundits predict their every move, so there are expectations "built in" to interest rates. If the Fed acts "as expected", then there are minimal changes following an announcement. Yesterday's announcement was a surprise mostly in the timing--many pundits had already predicted a half point cut later in January. So the impact was not overly dramatic.

NB: Not covered in this post is the differences in impacts between "Jumbo" and "Conforming" loans -- the magic number there is $417,000 because that's the mandated upper limit of loans that Fannie and Freddie can purchase from banks and re-sell--with a guarantee--to investors, creating a very liquid secondary market. Liquidity and guarantees lowers risk for banks, which helps keep rates lower for buyers in that bracket.

Update: In conjunction with the just released stimulus package comes news that Congress is evaluating whether or not to raise that $417K limit to $625K. If implemented, this will do a ton to create more affordable mortgage options in the DC area...more to come.


Read more: How do Fed rate cuts affect adjustable mortgages?

Read more: A slightly dated article that still does a nice job explaining impacts on different mortgage types.