Last week, Ben Bernanke and the folks at the Federal Reserve say they have no plans to raise interest rates until 2014. That means you’ve got at least two years to take advantage of the government’s ultra-low 0.25 percent rate on its Federal Funds.
Sounds like a great time to buy a new home, or take advantage of the low interest rates to refinance your current residence, right?
Well, not exactly.
While it’s tempting to draw a parallel between the interest rate on Federal Funds and mortgage loans, the correlation is shaky at best. It’s true that the Federal Funds rate and the Prime rate compare favorably; there’s also a relationship between the Fed’s rate and short-term loan rates, like a one-year adjustable rate mortgage, or ARM. But just because the Fed’s interest rate is expected to hold steady at that quarter of a percent rate for the next several years doesn’t mean mortgage rates will also stay at or near the historical lows we’ve seen over the past year.
The reason is complex. The most popular type of home loan on the market is the 30-year fixed loan, which has an interest rate that has bottomed out under four percent in recent months. However, even though the length of the term is 30 years, that doesn’t mean homeowners are holding on to their properties for the entire period. In fact, the average 30-year fixed loan is held for just seven years!
It’s because of this relatively short-term lifespan on a long-term loan that loan underwriters determine rates based not on the Fed’s interest rate – which, despite the Fed’s promise to hold the current rate steady for the next 24 months, typically fluctuates multiples times a year – but on five- and ten-year Treasury Constant Maturity bonds, also known as T-bonds. In fact, a comparison of T-bond and 30-year fixed loan rates over the past two years shows when T-bond rates dip, a drop in mortgage rates soon follows. Because T-bonds are less susceptible to the ebbs and flows of today’s turbulent market, the mortgage rates they influence are also largely protected from day to day changes.
Another key element that affects the mortgage market is inflation. Inflation plays a role in your mortgage application because it essentially acts as a financial vampire, stripping the loan’s value in the eyes of investors. For example, if you get a mortgage at a four percent interest rate – in the midst of two percent inflation – the total profit for the investor is two percent instead of the original four. That means when inflation goes down, you’re likely to see a drop in mortgage rates, since investors now have a wider profit margin; likewise, a rise in inflation also leads to a rise in mortgage rates.
Of course, there are other factors at play in the mortgage application process: the delays – ranging from a few hours to a few days – in securing an interest rate, your credit score, the size and length of the loan for which you’re applying, and market issues like supply and demand.
But the bottom line is this: while a low interest rate on Federal Funds is a good thing for a recovering economy, it’s not necessarily a good thing if you’re in the hunt for a new mortgage.