Most people get confused when The Federal Reserve talks about lowering or raising interest rates. The assumption is that mortgage interest rates are controlled by Federal Reserve Policy in the United States. This is not always the case. When the Federal Reserve talks about raising rates, they are not referring to interest rates charged for mortgages. They are referring to the Federal Funds Rate.

What is the Federal Funds Rate?

In general, is the overnight rate set by the Federal Reserve, that is charged by one bank that has excess money, loaning money to another bank that is in need of excess funds to meet reserve requirement set by the Federal Reserve.

Why do Banks need to borrow money overnight?

Banks are obligated by the Fed to have minimum reserve levels (10% or more) in either cash or held in reserve by the Fed. When outstanding loans held by one bank, fall below minimum reserve requirements, that shortfall can be made up when the bank with the shortfall, borrows money from another bank that has excess reserves or a surplus held by the Fed. These are usually short-term, overnight loans.

How does the Fed Fund Rate Impact the Economy?

When rates are low, the return paid on safe investments such as money market accounts, is lowered. There is less motivation to save and so, consumers generally spend more. Investors also look for riskier investments that offer higher returns.  Lowering the Fed Fund Rate, usually leads to lower returns on Treasury Bonds and lower borrowing costs, such as the interest paid on mortgages. Lower rates usually stimulate companies to invest in new equipment, plants and workers. The end result of lower rates, production is boosted and the economy grows because of the higher spending and increased investment.  

How is The Near Zero Fed Fund Rate Impacting The Economy Now?

It’s not really helping much. The rate is near zero, yet economic growth, business investment and increased employment still remain sluggish. There has been one benefit. When the Fed Fund Rate is extremely low, returns on investments tied to the dollar such as Treasury Rates are low and thus less attractive than returns on deposits held in other currencies such as the Euro and Yen. A weaker dollar leads to higher exports by the United States, which stimulates economic growth. (The problems in Europe and the waning growth in China, however, have curtailed much of the expected increase.)

Does the Fed Control Mortgage Interest Rates?

Not directly. The rate being charged for overnight loans between banks impacts the rates paid on bank deposits by investors, and the loan rates charged to borrowers. The lower rates also keep Treasury Bill rates down. The 10-year benchmark Treasury Bill rate being paid at present, is a mere 2%. That’s not much of a return.

Will the Low Rates Charge By the Fed, Keep Mortgage Rates Low?

Not necessarily. The Fed has also printed money through the use of QE1 and QE2. These policies have been designed to stimulate economic growth and job creation by flooding the market with additional money. The Fed has also spent a great deal of this money purchasing Treasury Bonds which fund the U.S. The increase in demand for Treasury Notes because of less desirable investment options, massive purchasing of Treasury Bond by the Fed,  and  weak economies world-wide, have kept the interest rates very low.  But, the policies  have also led to a nearly $16 Trillion U.S. Deficit. Once world economies start improving, making other investments more desirable, the U.S. will have to pay higher returns on Treasuries to fund the Deficit. This is why there is such great concern about the Fed’s Spending Policies leading to inflation. The end result could be higher mortgage interest rates, despite the Fed’s promise to keep the Fed Fund Rate near zero through 2014.

How Does The Fluctuation in the Fed Fund Rate Affect Buyers and Sellers?

If the Fed does raise rates in the future, as it must to avoid inflation, mortgage interest rates will rise.

For Buyers- If a buyer gets a mortgage, the cost of that mortgage could increase significantly. Buyers must keep in mind that the average rate for the past 40 years or so, has been 7-8%.

For Sellers– If mortgage interest rates increase, the pool of buyers that qualify for a mortgage to buy a home in every price point drops. As demand drops, so can housing prices, making the prospects of selling in the future, far riskier for sellers.