How Lower Fed Funds Rate Affects Mortgage Rates

related category image

Point of Interest

Fluctuations in the Federal Reserve target rate have wide-reaching ramifications for mortgage loans.

Lowering the Fed funds rate affects many things, including mortgages. It does this by encouraging banks and lenders to decrease the interest rate on loans and expand the number of loans they provide. In simple terms, lowering the Fed funds rate increases the supply of available money to banks that they can earn interest on, making it possible for them to offer lower interest on loans without losing as much net interest gain as they otherwise would.

Mortgage loans come in different types. One type of particular interest to people is the VA loan, a home loan backed by the Department of Veteran Affairs, which doesn’t require a down payment when purchasing a home. This kind of loan can make it easier for people to buy a home while the Fed fund rates are low, even if they don’t have the cash available for a down payment. VA loans are available to active service members and veterans.

What are Fed funds rates? 

Fed funds rates are defined as “…the interest rate at which depository institutions trade federal funds (balances held at Federal Reserve Banks) with each other overnight.” Reserve requirements refer to the fact that all banks are required to reserve some of their money as a guarantee for their customers, making sure that account holders will have immediate access to money when requested.

The Federal Reserve uses the Fed funds rates to intervene in the economic system to increase stability, especially in times of crisis, as is being seen during the coronavirus pandemic. For instance, they have lowered the Fed funds target rate, which reduces the interest rate at which banks borrow money from each other to meet their Fed funds reserve requirements and leads to banks and lenders offering lower interest rates for their customers. 

Lowering the Fed funds rates provides the banks with more money to work with, making it feasible for them to loan money at a lower interest rate. By increasing the availability of loans in this way, the Federal Reserve is encouraging a heightened movement of money through the economy, through an increase in loans coupled with a decrease in the risk of loans as captured by interest rates (the lower the interest rate, the less likely a loan is to be defaulted on).

Why does the Fed change interest rates? 

Interest rates are one of the Federal Reserve’s primary tools for stabilizing and preserving the economy’s health. Normally, it is often a method of controlling inflation. Increasing interest rates reduces the free movement of money and counters inflation while lowering the rates frees up money and stimulates the economy. The Federal Reserve aims for an inflation rate of 2% over time. This policy is designed to optimize the staying power of the American dollar and high rates of employment. During a crisis, such as the coronavirus pandemic, this goal has become tricky, if not temporarily unsustainable.

Beyond the minor alterations to Fed fund rates that occur in regular times, the Federal Reserve can alter the Fed fund rates in response to an economic crisis. By lowering the Fed funds target rate and freeing up the movement of money, the Federal Reserve is making it easier for businesses to avoid collapse during a time when the financial market is otherwise paralyzed. When loans are more affordable and available, they become a more viable way for businesses to avoid bankruptcy during an economic crisis of this nature. These loans will likely go towards covering costs of operation and employee wages during a time when actual paying business is at an extreme low. If affordable loans can sufficiently bolster lowered profits, then the companies can stave off bankruptcy and layoffs.

How do lower Fed funds rates affect mortgage rates? 

This lowering of the Fed funds rate has multiple effects upon mortgage rates. Many experts expect mortgage rates to take a dip, of varying degrees, while the Fed target rate remains low. When the Federal Reserve lowers the Fed funds rates, it increases the amount of money that banks can loan and earn interest on, because it reduces the rate of interest at which banks lend money to each other to meet their reserve requirement. In simpler terms, banks have cheaper access to funds and can loan money at a lower rate to a higher number of people.

How do lower Fed funds rates affect consumers?

For homeowners, the lowering of the Federal Reserve target rate can lead to the opportunity to refinance a home and end up with a lower interest rate on their mortgage loan. For people considering buying a home, the lowered Fed rate can make it easier and cheaper to obtain a low-interest mortgage. Even a couple of percentage points difference in mortgage interest rates can reflect hundreds of dollars difference in monthly mortgage repayments. These historically low Fed fund rates can create an excellent time for new homeowners to emerge and take advantage of lowered interest rates on mortgage loans.

Should I refinance my loan with lower interest rates? 

Knowing when to refinance a mortgage can be tricky, but when the Federal Reserve lowers its target rate is an excellent time to consider it. However, there are numerous factors and costs that go into the refinancing process. If you can achieve an interest rate reduction of one or more percentage points on your mortgage, you have the finances to fund the refinancing process and you aren’t planning to sell your home in the near future, then financing can be a smart move.

For example, if you have a home valued at $200,000, and you want to obtain a home loan for it, the monthly payments at 6% interest will be $1,000. With a 4% interest rate—just two points lower—the monthly payments on that loan would be $667.

Now, if you were refinancing a mortgage with $200,000 left on it, that could achieve a lower interest rate, but it would involve upfront costs. These costs include mortgage application fees, loan fees, insurance fees, property fees and closing fees. In this case, it can be useful to get a tally of the fees and costs from the bank you’re considering and then calculate how much money you would save on the lower mortgage rate in comparison to the amount needed to spend to initiate the refinancing of your mortgage. If the amount saved on interest is significantly higher than the amount spent on refinancing, it can be a good idea to refinance.