So once again, the Federal Open Market Committee raised the Fed Funds target rate by a quarter point. The target Fed Funds rate now sits at 0.75% – 1%. How will this effect mortgage rates for those looking to buy a home this spring? Likely, not very much.
To help understand this better, an explanation of interest rates is warranted. First off, the Fed does not set mortgage rates. When you hear on the news that the Fed is going to raise rates, that means they are raising the Fed Funds target rate. This is the rate at which banks lend excess money to other banks.
What does that mean? Well, every bank is required to keep a certain amount of cash on reserve at the Federal Reserve Bank. When banks have cash in excess of their reserve requirement, they can lend it to other banks that need additional funds to meet their own reserve requirement. For example, say Bank A has a reserve requirement of $400,000 and their cash balance at the Fed is $600,000 at the end of the day. Meanwhile, Bank B has a reserve requirement of $500,000 but their cash balance at day end is $300,000. Bank A can lend their excess to Bank B to meet the reserve requirement. The loan is made overnight, i.e. the money is returned the next day. The rate is negotiated between the two banks, but it approximates the Fed Funds target rate.
This is the only interest rate that is directly controlled by the Fed. The Fed Funds rate can have an impact on other rates. However, long-term rates are predominantly controlled by market factors.
Mortgage Rates and the 10 Year Treasury Bond
Take the 30-year fixed rate mortgage. This rate has historically been benchmarked to the 10-year Treasury rate. Why the 10-year Treasury? Because the average 30-year mortgage pays off or refinances in 10 years. Typically, 30-year fixed rate mortgages run about 170 basis points (1.70%) above the 10-year Treasury rate. This spread accounts for the increased risk the bank is taking by lending money to a borrower rather than investing in a government bond.
The market rate on a 10-year Treasury bond is currently around 2.58%. According to Bankrate.com, the average rate on a 30 year fixed mortgage is currently 4.25%. If you were lucky, you bought or refinanced when interest rates were at their low last July. The 10 year Treasury dropped to 1.37% in early July with 30-year mortgage rates in the low 3’s. What happened to drive rates up after their all time lows? The Fed only raised rates once during this time period prior to yesterday. The main driver has been improved outlook on the economy, which will drive long-term rates.
If the Fed hints at more aggressive increases to interest rates (which it has) that will likely push long-term interest rates up. But in the end, long-term rates will be determined based on the outlook for the economy. Positive signs for business such as decreased regulation and lower taxes have led rates to increase since the election (the 10-year Treasury is up about 0.75% since the election). But execution of these policies is what will determine if rates continue to go up (optimism has already been built into the market). If the economy trips up, then market rates will go back down as investors flood to the safety of bonds.
Make your home buying decision independent of rates. Don’t rush into a big home purchase now because you fear interest rates are going up. In 2016 the Fed had predicted 4 interest rate increases and wound up with only one at the very end of the year. The economy is looking better now, but that’s no guarantee that it will continue to churn along and interest rates will increase.
Additionally, even if rates do increase, it’s not likely that we will see as big as an increase as we’ve seen since last summer. Again, a lot of the increase to market rates thus far is due to increased optimism. We likely won’t see long-term rates increase all that much in the coming weeks because the increase was anticipated and already built into the market. Future rate increases are anticipated as well. Therefore, it’s unlikely that mortgage rates will push up above 5% this year.