Dennis' Mortgage Blog

This past Tuesday the Federal Reserve Board of Governors surprised the world by announcing a cut in key interest rates of 0.75% (three-quarters of one percent) before the stock markets opened for business. The purpose of this cut was to ease anxiety and a possible significant decline in U.S. stock prices following a huge drop in financial markets the day before in Europe and Asia (U.S. exchanges were closed in observance of Martin Luther King Day). The cut worked, stocks did drop on Tuesday but were up substantially Wednesday and Thursday. Confidence was somewhat restored and a market crash was averted.

Following an email I sent out to my clients and contacts in my database I received many calls and emails along the lines of, “what does this mean to me?” Here is what cuts to rates by the Federal Reserve means to most homeowners: not much.

When the Fed cuts rates it trickles through the financial markets and the key rate that is affected that impacts consumers is the Prime Rate. So called because it is historically the rate by which banks charged their best and most qualified borrowers—typically large companies and corporations. As Home Equity Lines of Credit (HELOCs) became more prevalent in the American mortgage markets the Prime Rate became available to millions obtaining HELOCs. The Prime Rate is used as the index for HELOCs and subsequently other credit instruments—some credit cards and large consumer loans most notably.

Unless you have a HELOC the reduction in rates by the Fed will have little direct effect. Most auto loans are fixed rates so if you have one it does not impact you. If your mortgage is a fixed rate, or an interim ARM in its fixed rate period, you are not impacted. Unless your credit card is tied to an index your credit card rates on any outstanding balances are not affected. For most Americans, and most American homeowners without HELOCs, the reduction in these rates will have no direct impact on you.

Indirectly there is significant impact on many more people and ultimately most Americans. When the Fed lowers its rates it is making it cheaper to borrower money—loosening the credit markets. The lower rates they are charging member banks to borrow money the lower rates those banks can charge their clients to borrow money. Corporations and small businesses looking to make capital investments in their businesses will be able to do so at lower costs and will be more likely to make these investments—investments which typically result in more jobs.

Slowly the lower Fed rates will impact the yield (rates) on Treasury bills which will lower the rates paid by those with Adjustable Rate Mortgages. This will make monthly mortgage payments lower for those with ARMs, and slowly over time reduce the number of ARM borrowers in default or foreclosure. This will level out the housing markets and bring stable prices to most areas of the country.

While there is rarely an immediate impact on the rates for fixed rate mortgages (typically Fed moves are predicted in advance and the market moves accordingly before the Fed meetings. As you can see by the chart below the Prime Rate has moved dramatically in the past seven years, but the movement in 30 year conforming fixed rates not nearly as significant. The “line in the sand” alludes to what appears to be an unbreakable barrier for fixed rates that has been barely breached once and that was immediately following 9/11.

So if you are looking for a home mortgage, and for rates to drop because the Prime rate has dropped you can see that we are near the bottom of the range. Will we break through in this cycle? Possibly, however statistical data says the break through will be difficult.

How does the Fed rate cut affect you? It eases credit for all the markets, it lends some confidence—or at least allays concerns—for investors and consumers, and it serves to encourage economic growth and expansion. In the long run these are the principals that have us still in the longest period of economic growth in post-WWII history—a cycle that while slowing down has not yet reversed from growth to contraction.

Dennis