What Does an Increase in the Fed Funds Rate Mean to You?

12 Dec

What Does an Increase in the Fed Funds Rate Mean to You?

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By Doug Goelz, Mortgage Services

By the time you read this article, the Federal Reserve may have raised the Fed Funds rate by ¼%.  If the Fed didn’t raise the rate this month, they will soon when they think the economy shows enough signs of recovery and strength.

What does the rate increase mean to you?  Probably the clearest impact is an increase in the Prime Rate charged by commercial banks.  If the Fed Rate increases, the Prime Rate (at 3.25% before any Fed increase) will increase by the same amount.  The Prime Rate is important to you because many other rates, such as those on Home Equity Lines of Credit (HELOCs) and many credit cards are tied to the Prime Rate.  An increase in the Fed Funds Rate = an increase in the Prime Rate = higher rates on credit cards and HELOCs = higher payments for consumers using HELOCS and credit cards.

The impact on mortgage rates is less clear.  Mortgage rates follow the rates on 10 year bonds more than they follow the Fed Funds rate.  Nevertheless, an increase in the Fed Funds rate points to an overall increase in rates in the US economy, and both the 10 year bond and mortgage rates eventually will reflect the overall increase in rates.

The rates on many Adjustable Rate Mortgages (ARMs) are tied to the LIBOR rate.  Like mortgage rates, LIBOR is not tied directly to the Fed Funds Rate, but will increase if there is a general increase in rates in the economy.  If a Fed Funds rate increase sparks/signals a general increase in rates in the economy, LIBOR will rise, rates on adjustable rate mortgages will rise when their rates adjust, and monthly payments will increase for those who have ARMs.

There has been speculation for months that the Fed will increase the Fed Funds rate, though, so some people think that the 10 year bond rates and mortgage rates already reflect the anticipated increase by the Fed.  That is, bonds traders have believed for months that rates in general will increase, and they have built in the anticipated increase into their bond rates.  This line of thinking would lead one to conclude that a Fed Funds rate increase will have little immediate impact on mortgage rates.

Even if mortgage rates move in lockstep with an increase in the Fed Funds rate, remember that the increase will not be more than .25% at a time (and could be less).  Mortgage rates are still very low by the standards of the past 50 years, and still will be very low by historical standards.

The monthly payment on a $500,000 loan increases by $72.62 per month if the rate increases by ¼ %.  This type of payment increase is tolerable by most people buying a home, so it isn’t anticipated that a small increase in mortgage rates will dampen the real estate market in the Bay Area.

On the other hand, for those considering refinancing their current mortgage, a small increase in rates on the potential new loan may mean that refinancing their current mortgage doesn’t make sense anymore.

Factors other than a Fed Funds fund increase have a potentially bigger impact on mortgage rates.  The world economy and the perceived safety (or lack thereof) of US financial markets can impact mortgage rates.  For example, turmoil in other economies such as China and Europe can be good for US mortgage rates.  If investors around the world think that the US is a better place to invest their money than another country, then money flows into the US and the yields on bonds can drop.  Here is why: if more investors want to invest in bonds, the bond issuers can pay lower rates and sell just as many bonds.  So, although a Fed Funds rate increase could have some impact on mortgage rates, other more global factors, such as regional economies outside of the US, and strife and conflict around the world, could have even greater impact on mortgage rates.

Questions?  Feel free to get in touch with me at 415-730-4665 or doug@emortgageservices.net