Established in 1913 by the Federal Reserve Act, the Federal Reserve System (or simply “the Fed”) is the central bank of the United States. The Fed’s purpose is to maintain the financial stability of the country through its powers of monetary policy that influence money and credit conditions.
The Federal Reserve’s Effect on Mortgages
The Fed itself has no direct ability to set interest rates for mortgages. Instead, the Fed sets what is called the “federal funds rate,” which is the target range of interest rates that banks will lend or borrow overnight of another bank’s money stored at the Federal Reserve. US banks are required to keep a certain percentage of their deposits in the Federal Reserve known as a reserve requirement, plus enough to cover withdrawals, but any excess reserves can be lent to other banks needing to meet reserve requirements.
The Fed cannot obligate banks to charge an interest rate within the range outlined by the federal funds rate, instead, the actual rate of interest charged by one bank to another is negotiated between the two. However, to influence the movement of interest rates to the Fed’s targets, they increase or decrease the supply of money. To influence an increase in the federal funds rate, the Fed will sell government bonds to absorb money from the system. The opposite is true for decreasing the federal funds rate; the Fed will introduce money into the system by buying government bonds.
These interest rates impact the prime rate, which is the lowest interest rate lenders offer their most creditworthy borrowers on loans, credit cards, and mortgages. These short-term interest rates have the most impact on adjustable-rate loans which are subject to fluctuations in interest rates as the market changes.
Mortgage rates in particular closely correlated with the 10-year Treasury, or the yield on the 10-year Treasury note. Lower federal funds rates do not have an impact on the 10-year Treasury yield but can have an indirect influence on them. 10-year Treasury notes are considered to be a safe haven asset as they are backed by the government. Historically, when interest rates on mortgages are low when yields are low. This factor is most important in long-term fixed-rate mortgages that are paid off over 15 to 30 years.
These tools are used by the Federal Reserve to maintain economic stability within the United States and promote employment for the country’s citizens.
The Economy’s Effect on Mortgages
Just as the Federal Reserve has an impact, albeit an indirect one, on mortgage rates, the economy also plays a factor. Both good and bad economic news influence mortgage rates, causing them to rise and fall accordingly. Good economic conditions usually correlate with high-interest rates, as lenders face increased demand. The opposite is also true. Bad economic news, like rising unemployment rates, decreases in the stock market, or national and international events cause mortgage rates to drop as demand decreases in response to economic conditions. Fewer homes being built or listed for sale also decrease the demand for mortgages, causing the interest rates to decrease as well. In these cases, supply and demand is the prime influencing factor on a mortgage.
How Inflation Impacts Mortgage Rates
In addition to the Federal Reserve and economic conditions influencing mortgage rates, inflation also plays a role. Inflation, the increase in costs of goods and services over time, often causes interest rates to rise. As inflation increases and consumers have a reduced purchasing power, mortgage lenders increase interest rates so that they can continue to make a profit on the loans they provide to borrowers.
Mortgage interest rates are dependent on many factors, those that pertain to the individual borrower and those that influence nationwide market conditions. When it comes to economic factors, the Federal Reserve has an important, yet indirect, impact on mortgage rates. The Fed sets the federal funds rate banks use to determine interest rates for overnight lending of funds to other banks, which has downstream effects on interest rates for short-term loans and variable-rate loans. 10-year Treasury notes are more closely related to interest rates for long-term loans like 15 and 30-year mortgages. Since these factors cannot be changed, a borrower should make sure that they are creating a credit profile that favors low-interest rate home mortgages.
