The Fed Rate Cut(s) and How It Affects You

There are still a lot of homeowners that think when the Federal Reserve cuts "The Rate" that this will automatically translate into lower mortgage rates. Let me define three key terms that you need to understand so you can assess the impact of the Federal Reserve's rate reduction.

The Discount Rate - is the rate at which The Federal Reserve's twelve regional banks lend money to their Member banks - normally for short periods of time up to thirty days, generally only overnight. This interest rate was cut by .75% or 75 basis points on January 22, 2008 to 4%. Typically the Discount Rate is 1% or 100 basis points higher than the Federal Funds Rate - at the moment it is only .50% or 50 basis points higher than the Federal Funds Rate.

The Federal Funds Rate - is the target rate the Federal Reserve sets in which private lending institutions (banks) lend money to one another - normally for very short periods of time, again overnight. This target rate was cut on January 22, 2008 by .75% or 75 basis points to 3.5%

The Prime interest rate - is the rate that banks lend money to their "Prime" customers, this rate is 3% higher than the Federal Funds Rate, therefore, as of January 22, 2008 it stands at 6.5%. The Prime interest rate is also used as an index for adjustable rate loans - generally second mortgage loans on homes and credit card debt. Therefore if you have a Prime based loan, then you will be directly affected by the Federal Reserve interest rate cuts. Further, when used as an index you will notice that there is a margin on the adjustable rate loans that can be a negative or positive percentage (this is a fixed percentage for the term of the loan). For example, if your Home Equity Loan is Prime minus .25%, the new rate will be 6.25% next month or if your Home Equity loan is Prime plus 1%, then your new rate will be 7.5% next month -- check the terms of your loan. In the case of some credit cards generally the rate is based on Prime plus a high margin.

Is there a relationship in fact when the Federal Reserve cuts these key interest rates? The answer is yes; the Federal Reserve, by cutting these rates, in fact is creating greater liquidity in the banking system as well as signaling the desire to have overall interest rates decline in the credit markets in general. The Federal Reserve has the ability to increase or decrease the money supply via purchasing or selling government securities respectively (open market operations) or cutting the key interest rates discussed above. The intent is to give the banks greater liquidity to lend money out - however if the banks don't lend then the policy will not have the desired effect. The general relationship to typical mortgage interest rates when the Fed cuts rates is negative. The reason for this is that the Equity Markets (Stock Market) typically favor a rate cut and therefore investors buy stocks on the cut and take money out of bond positions (selling mortgage bonds) that drive up interest rates. So in 2007 when the Fed cut its rates the typical 30 year fixed rate mortgage actually increased.

The greatest relationship to mortgage interest rates is the stock market. The wisdom is when the stock market sells off, the money flows to government guaranteed bonds thereby lowering interest rates. The fact is that the mortgage market is a market of buyers and sellers of the mortgage debt and interest rates have an inverse relationship to the price of the security - when money flows into the credit market (bonds are purchased) the yield or the interest rate paid to the purchaser decreases in direct relation to the price paid. This can be a confusing concept but the rule of thumb is if the stock market goes down in price so goes interest rates in the same direction -- down.

The current consensus is the Federal Reserve will continue to cut its key interest rates at the end of the month again and during subsequent meetings. The lowest the Federal Funds rate in the recent past has been 1%. We may be headed there again. If this happens, then we are looking at the Prime interest rate to be at 4% and this will make a lot of Home Equity loan holders very happy but at the same time their retirement savings will suffer so don't be too giddy.