This is part of a special series on the USA real estate industry in the period of the coronavirus (COVID-19) pandemic. Read others in the series here.
We’ve all heard it by now… Rates are falling. Rates are at an all-time low. Etc. As a potential home buyer, what does this mean for you? In this article, I explain what these rates are and how they impact mortgage rates and ultimately, you as a home buyer.
What is the Fed Funds Rate?
The federal funds rate is a targeted interest rate decided by the Federal Open Market Committee and updated 8 times a year. It is the rate at which banks lend to each other overnight. These funds are typically held at the Federal Reserve, so the banks can meet the minimum reserve requirements. This rate is commonly known as a benchmark rate as many other financial instruments use it as a point of reference.
So how does the Fed rate impact mortgage rates?
The Fed rate impacts variable rate mortgages, also known as adjustable rate mortgages, as the variable component of the mortgage is pegged against the Fed rate.
For example, in a 5/1 ARM at 3%, the first 5 years is fixed at 5% and then it floats every year depending on how the Fed funds rate changes.
However, a common misconception is that the Fed rate has a direct impact on fixed mortgage rates. Indirect, yes but not direct. Instead, mortgage rates are usually more aligned with Treasury yields as they compete for the same pool of investors. Of course, different mortgage types should be compared to like-types of Treasury bills. So 30 year mortgage rates are compared to 30 year T-bills and not 10 year T-bills.
So, if the Fed cut rates, will mortgage rates also fall?
Mostly, but not exactly.
At this point (May 2020), we are just in a historically low rate environment for just about any kind of interest rate and this includes the Fed funds rate and mortgage rates. The Fed rate is basically zero (target 0-0.25%) so there isn’t anything much more to cut and some of this is me speaking hypothetically.
On the contrary, we’ve seen mortgage rates behave erratically and even rise while the Fed rate was cut. This is because there are other factors that determine mortgage rates like the demand for mortgages and other asset types that investors can put their money into. In this case, the low mortgage rates caused a boom in people seeking to refinance and leading to an overload in applications for lenders. Lenders were unable to keep up with the demand, causing mortgage rates to rise slightly even while Fed rates dropped.
So if I can’t rely on the Fed rate, how do I check mortgage rates today?
Firstly, the only way to ‘get a mortgage rate’ is to submit an pre-approval application to a lender, who will then pull your credit score and give you a range of rates for different types of mortgages (length, variable vs. fixed etc). Most people who are in an initial stage of search will not do this as it results in a hard inquiry on your credit report.
Instead, what you can do is a get a gauge of where rates are trending and where they are forecasted to go.
According to their site, Freddie Mac surveys lenders on the rates and points for their most popular 30-year fixed-rate, 15-year fixed-rate and 5/1 hybrid amortizing adjustable-rate mortgage products. Remember, these are aggregate rates and reflective of the general market trend, but not based on your credit report yet.
This is not exactly the main function of the calculator but it works great for what we’re trying to do. If you know what credit score range you’re in, this spits out the estimated mortgage interest rate for different types of mortgages.
So hopefully now you understand the relationship between the Fed rate and the mortgage rate and why the recent trends have been what they have been. Any questions? Comment below!