The Feds Cut Rates Again – Why Doesn’t My Mortgage Rate Go Down?

The dramatic cuts in interest rates by the Federal Reserve Bank have caused many people to ask why mortgage rates are not dropping as well. It’s a legitimate question that has several answers and I’ll try to explain in simple terms…

The first, and most important, thing to understand is that the Federal Funds Rate is simply a suggested rate of interest that one bank can charge another bank for an overnight loan. At the end of each business day, banks must have certain amounts of cash on hand to meet reserve requirements as set by law. One bank may need to borrow to meet the requirements, while another bank may have surplus funds available. Banks can negotiate the actual interest rate on these overnight loans – they are not forced to charge the Fed Fund Rate.

Secondly, one has to realize that an overnight loan is extremely short-term while a 30-year fixed-rate mortgage is an extremely long-term loan. It is easy to commit funds at a certain rate for a short term but it is much more difficult to determine what the rate should be for a long term. Many factors such as anticipated economic growth and inflation rates must be taken into consideration in setting a rate of interest that would draw investors.

Now we have to take a look at U.S. Treasury Bonds. As we all know, T-Bonds are backed by the full faith and credit of the United States Government. In other words, T-Bonds are a risk-free investment. T-Bonds serve as a benchmark risk-free interest rate. Investors (you, me, professional money managers and everyone in-between) want to get the best possible return on their money based on the amount of risk involved.

Given the fact that the average length of a 30-year fixed-rate home mortgage is actually about ten years, it makes sense to compare investing in home mortgages (with risk) to 10-year fixed rate T-Bonds (no risk). The interest rate has to be higher on the mortgage securities or no one would invest in them.

As the number of foreclosures and defaults has increased (increasing risk), mortgage interest rates have had to go up in order to attract investors. This is the so-called “secondary market” for mortgages.

As many people who have purchased homes can attest, often the bank that gave the buyer the mortgage is not the bank to which buyers are making their payments. Shortly after closing, often buyers get a letter explaining that a different bank now has their mortgage. This is because the original bank sold their mortgage to another financial institution.

Many factors affect movement in mortgage rates – not the least of which is competition for money. An investor has money and a homebuyer needs to borrow money. Where can the investor get the best return?

This has been an overly simplified explanation of a very complex subject but I hope it helps at lease partially explain why changes in the Federal Funds Rate as discussed in the press have almost nothing to do with the mortgage rate.

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