Who The Fed Are You?
By Barry Habib
The Fed has been very active during the past six months, hiking rates five times for a 1.25% increase. But what is the Fed controlling and what are they trying to do? More importantly, how will this affect rates on mortgage loans?
The Fed can only control two types of rates – The Discount Rate and the Fed Funds Rate. The Discount Rate is the rate which member banks can borrow directly from the Fed on an overnight basis – essentially, a one day adjustable rate. The Fed Funds Rate is an overnight target rate for banks to charge each other. While the Fed sets the target, the actual rate banks charge each other may vary slightly.
The Fed would like to see the economy grow at a healthy pace, but not so hot as to spur inflation. The manipulation of the Fed Funds and Discount rates can help to stimulate or slow economic activity. Theoretically, lower borrowing costs will influence more borrowing...and therefore more spending. This additional spending tends to perk up the economy. The reverse can happen when the Fed tightens the purse strings by raising rates, which normally slows down the economy, since it has become more expensive to borrow and spend.
So where does the Prime Rate come in? The Prime Rate is very different than standard mortgage rates. The Prime Rate is tied to the Fed Funds Rate. Banks borrow at the Fed Funds rate and add a mark-up of around 3% to come up with their "Prime" lending rate...the overnight rate they lend to their “Prime” or best qualified customers. Again, “overnight” describes the time that the rate is good for, not the time of the loan. This rate can be an index or benchmark for most home equity lines of credit as well as business loans. So you can see that when the Fed acts, they do not directly control the Prime Rate...just one of the rates that influence it.
Mortgage rates often act in the opposite direction from the direction of the Fed action. Why does this happen? Although it may be very counter-intuitive at first, it really makes a lot of sense.
Pretend you are a lender, who is lending your own money. Assume you grant a loan that pays you back $1,000 per month and the loan is fixed for 30-years. Today, you can buy $1,000 worth of goods and services with those proceeds. But what about 2, 5, 10, 15 years from now? Can that same $1,000 per month go as far? The easy answer is no. Why? Because of inflation. Inflation eats away at the value of value of bonds - like mortgages - over time.
So as a smart lender, if you felt inflation were on the rise...which would erode the value of your mortgage investment over time...you would make sure you quote a higher rate the next time you did a loan, in order to offset the expected future erosion of value from inflation. This is why mortgage rates go up when inflation is feared to be rising.
Now we know how inflation can eat away the value of bonds, like mortgages. So…if the Fed announced "we are going to hike rates – this will slow the economy, tighten monetary policy, and choke off inflation", this would be very good news for bond holders. Your investment would retain more of its value longer or buying power and be worth more. This may prompt you to actually quote lower rates to new borrowers, which is why rates on mortgages decline when the Fed hikes.
Of course, concepts like this are not just important to know, but to really understand and communicate so that you can be an even greater Trusted Advisor to your clients. Mortgage information - and misinformation - is running rampant, and our clients are being bombarded every day. You need to be able to guide your clients with authority, and have the knowledge in Fiscal Literacy to do so. There are a few different tools and resources that can help keep you educated and informed, such as www.mortgagemarketguide.com, www.bloomberg.com, and www.cnbc.com. Check them often to stay on top of economic shifts and trends like Fed moves, and use your knowledge to keep ahead of the competition.
Barry Habib is the CEO of the Mortgage Market Guide. This service helps over 10,000 of America's best Loan Originators. For a FREE TRIAL to the Mortgage Market Guide go to http://www.mortgagemarketguide.com/membership/trial.php