By Dale Shin
The Federal Reserve System, also known as the “Fed,” raises and lowers their federal funds rate regularly. Recently, the Fed lowered the rate to 0%! What many people mistakenly may think is that home loan rates will now also be at zero percent interest. Unfortunately, that is not the case. To explain why, let’s look at what the Fed is, what they do and what actually determines home loan interest rates.
The Federal Reserve System is the central bank of the United States and has a primary function of keeping the US economy healthy. In very simplistic terms, the Fed monitors and adjusts their policy as necessary to keep the economy flowing and growing. One of the tools they use to do this is by adjusting the federal funds rate. The federal funds rate is the interest rate that the Fed suggests banks charge each other when lending to each other (this is an interesting topic that is beyond the scope of this article so for more info on this, check out this article from Investopedia). The Fed cannot require that banks and lenders use this federal funds rate but most do and use this rate to set their prime rate for consumer debt, such as the interest rates on credit cards, lines of credit and business loans. However, banks and lenders do not use this rate to set interest rates on home loans they issue. Therefore, a federal funds rate of zero percent will not equate to a zero percent home loan interest rate.
Instead, banks and lenders base their home loan interest rates on the rates of another government entity, the United States Treasury. The specific Treasury instrument home loan interest rates are based on is the 10 year Treasury note yield curve (this also is a topic beyond the scope of this article so check out this article also from Investopedia). Many lenders add their margin rate on top of the 10 year Treasury note yield curve to set their interest rates for the home loans they offer.
The 10 year Treasury note had steadily been decreasing throughout 2019 and into 2020. On March 2, 2020, the 10 year Treasury note yield curve was at 1.10 and had fallen to 0.92 as of March 20, 2020. Home loan interest rates correspondingly have been decreasing as well throughout this period hitting a historic low of 3.29% on March 5, 2020, the closest rates have been this low was in late 2012 when rates were at 3.35%. As of March 19, 2020, however, the rate was at 3.65% for a 30 year fixed rate mortgage according to Freddie Mac. If home loans are tied to the 10 year Treasury note which is continuing to decrease, why then is the interest rate going higher?
The answer is because of the tremendous demand for home loan refinances in the past few weeks. Many homeowners are finding they could save money or even pay off their loan faster and still make the same monthly payment by refinancing to a shorter 15 year mortgage at even lower rates. The increased number of refinance applications is making it hard for lenders to keep up with demand. Using the basic principle of supply and demand, the increased demand and limited “supply” is driving up interest rates.
Even though rates are creeping up due to this increased demand, it is still very low on a historical basis so for homeowners who have no plans to move for the next 10 years or so, it can make sense to refinance. Before refinancing, a homeowner should consider these factors:
The interest rate on your current loan is at least 1-2% higher than the current rates
You intend to stay in the home enough years to break even from the refinance costs
Your current loan is an adjustable rate mortgage (ARM) that can result in higher monthly payments
Your current loan has more than 15 years remaining
To see if refinancing makes sense for you, check out personal finance expert Dave Ramsey’s page on this topic.
You may wonder why did the Fed decrease the federal funds rate so drastically? At the time of writing this article, the world is being gripped by the coronavirus pandemic. COVID19, a highly contagious strain of coronavirus, has spread to practically every country across the world. It is a respiratory disease that is causing many people to become severely ill, with fatal consequences for some. The COVID19 virus can be transmitted via vapor droplets from an infected person. If the infected person coughs or sneezes, vapor droplets containing the virus can infect a healthy person by entering through their mouth, nose or eyes. Vapor droplets that also land on a surface can survive long enough for someone to touch the surface and subsequently touch their mouth, nose or eyes. At the moment, there is no known cure nor vaccine for this disease.
To limit its spread, many countries have locked down, ordering people to stay home and keep a safe “social distance” away from each other. Non-essential businesses and places where large numbers of people congregate have also been ordered to close until further notice. This lockdown has interrupted our normal way of life, disrupting the economy and making it impossible for individuals and business owners to earn an income. Without income, it will eventually become impossible to buy food, pay the rent and utilities, pay for medication, let alone pay any bills.
The drastic lowering of the federal funds rate is in response to this economic disruption. The Fed had been progressively lowering the federal funds rate which was at 2.25% – 2.5% a year ago to the current target range of 0 – 0.25% to try and help people and businesses at this time. By lowering the federal funds rate, the Fed, in their words, is trying to “support economic activity, strong labor market conditions, and inflation returning to the Committee’s symmetric 2 percent objective.” Basically they are trying to help the current situation by adjusting what they can control. What this should translate to is lower interest rates on personal credit cards, lines of credit and business loans which should help make it more affordable for individuals and businesses to borrow money as necessary. The lowered federal funds rate is intended to make it possible for people and businesses to stay afloat by borrowing “cheap” money until our lives and business can return to normal.
In summary, it’s important to recognize that the federal funds rate is the basis for consumer debt interest rates while home loan interest rates are based on the 10 year Treasury note. That is why a 0% interest rate announced by the Fed will not necessarily mean home loan rates will go down to zero percent as well.