Do Mortgage Rates Always Go Up with a Fed Rate Hike?
If you’re shopping for a mortgage around the time the Federal Reserve is expected to raise rates, you’re likely to hear warnings to buy right away, before interest rates go higher. But while the Federal Reserve’s decisions can have an effect on the mortgage industry, they don’t always result in higher rates.
The Fed isn’t directly changing mortgage interest rates. They’re adjusting what’s called the federal funds rate. And in recent history, there have been periods in which the fed funds rate was rising, but fixed mortgage rates hardly moved at all. But there are also certain types of mortgages, such as adjustable rate mortgages, that are more affected if the Federal Reserve raises or lowers the federal funds rate, although the reason has to do more with the indexes that the ARMS are tied to than the actual federal funds rate itself.
We’ll discuss what the Fed funds rate is, how it has influenced rates in the past, and discuss whether rates always go up with a Fed funds rate increase.
What is the federal funds rate?
The federal funds rate is the interest rate that banks charge each other to trade money overnight. The rate charged for these trades is determined by the market, but the Federal Reserve establishes targets and can help implement them by buying or selling government bonds.
Banks trade money to adjust how much money they have in their reserve accounts to meet regulatory requirements. If a depository institution has more than enough money, it lends it to other banks that need larger balances. The rate that the borrowing bank pays to the lending bank is decided between each institution, and the weighted average rate is called the effective federal funds rate.
While the Federal Reserve’s actions may influence the direction of a variety of interest rates offered on loan products, the Fed doesn’t actually set them. Congress tasks the Federal Reserve with a mandate to keep inflation in check and maximize employment.
There are eight times in the year when the Federal Open Market Committee meet to determine a federal funds target rate. If the economy is doing well, the committee will set a higher target rate to keep inflation from going too high, while a weak economy will usually indicate the need for a lower target rate.
Because the federal rate rate is a central interest rate in the financial markets, it influences the rates banks end up charging for everything from short-term interest rates on credit cards and savings accounts, to longer term rates on mortgages. The Fed must constantly consider a variety of economic data including trends in prices and wages, employment, consumer spending, income, business investments and foreign exchange markets when setting and resetting its federal funds rate target.
When the federal funds sets a higher target rate, the result is usually higher interest rates for all types of loans including mortgages. The reverse is true when the federal funds rate target is lowered — mortgage rates tend to gradually drop during these times, along with rates for other lending products.
The federal funds rate is an overnight rate, meaning it can change daily, while a mortgage security is held over a much longer time period, which makes changes less frequent. You’re more likely to see noticeable changes in short term credit accounts like credit cards or car loans than mortgages when the federal funds rate is adjusted.
Federal funds rate vs. mortgage rates
While many people have been concerned about how high rates might rise this year, from a historical perspective, the fed funds rate is very low. The graph below shows the path the rate has taken since the 1950s.
Even with the recent increases, the rate is still near the lowest levels of the last 50 years.
The next graph shows historical 30-year fixed mortgage rates from 1971 to 2019. The graph indicates mortgage rates do seem to follow the same path as the Fed funds rate, but the rises and falls are much less severe.
The first thing you’ll notice is the big drops and rises in the federal funds rates. The Federal Reserve made these adjustments in 2001 to offset a weak economy in the United States. The attacks on the United States on September 11, 2001, required more action to keep the economy stable while the country recovered.
The second thing that becomes obvious is how little fixed rate mortgage rates moved during this period. Even from 2004 to 2005, when the Fed funds rate nearly doubled, the increase in average mortgage rates was barely noticeable.
Amid all of the ups and downs of the federal funds movement, mortgage rates really didn’t move significantly either way, which shows how little impact the Federal funds rate can have on fixed mortgage rates.
Why the federal funds rate and mortgage rates don’t move the same way
They don’t move together because the factors that influence the federal funds rate aren’t the same as the ones that go into mortgage rates, said Tendayi Kapfidze, chief economist of LendingTree. Mortgage rates are mostly influenced by concerns about inflation, and how much demand there is for mortgage-backed securities.
Inflation affects how much profit banks make, and when there is higher inflation, bank profits will drop unless they gradually increase rates to keep up with inflation. “When lenders start to expect inflation to increase, they’ll start to raise interest rates across the board,” said Kapfidze.
One example of the disconnect between the fed funds rate and 30-year fixed mortgage rates can be seen from 2001 to 2006 when the federal funds rate was increasing and decreasing rapidly, but mortgage rates moved very little either way.
|Federal Funds Rate vs. Mortgage Rates|
|Year||Average Fed funds yield||Average 30-year fixed mortgage rate|
The federal funds rate has a bigger effect on adjustable rate mortgages
Up until this point we’ve been talking about how longer-term fixed mortgage rates are affected by increases in the federal funds rate. Adjustable rate mortgages follow much different patterns.
If fixed rates were high at the time you took out your last mortgage, your loan officer may have suggested you consider an adjustable-rate mortgage, or ARM, as they are more commonly known. ARMs feature a low fixed rate for a predetermined period of time, usually 3, 5 or 7 years, and then adjust based on a specific index.
The two most common indices used are the London interbank offered rate (LIBOR) and the 11th district monthly weighted average cost of funds index (COFI). Both are tied to economic and financial conditions and can cause big increases, and sometimes even decreases in your interest rate and monthly mortgage payment.
These indices tend to follow the federal funds rate a lot more closely.
|Federal Funds Rate vs. Major Indices|
|Year||Fed funds rate||LIBOR||COFI*|
*ARM Indexes: 11th District Cost of Funds (COFI) from 2001-2006 (December-only index value)
This means your payment would fluctuate pretty widely on an adjustable-rate mortgage. Here’s an example.
Let’s assume you started with a 5/1 adjustable-rate mortgage at a starting rate of 6.375% in December of 1996, with adjustments of 2/2/6 tied to the LIBOR index. Your loan amount was $200,000, meaning you had a starting payment of $1,247.74 per month
Your first adjustment would have been capped at 2% above your start rate, with a 2% margin for maximum adjustments every year after that, with a maximum cap of 6% above the rate you started. The table below shows how your payment would have adjusted each year with the changes in the index values.
|Adjustable-Rate Mortgage Payments as Rates Change|
|Year||Index||Margin||Fully indexed rate||Monthly payment|
The big drops in the index had a very favorable impact on your payment at first, but as the federal funds rate begins to rise, the payment increases from a low point of $857.30 to its highest level of $1,326.58 — an increase of $469.28 per month.
This is why the hikes to the fed funds rate can be scary if you have an adjustable-rate mortgage. If you don’t like fluctuations in your monthly mortgage payments, a fixed-rate mortgage will provide more stability even in periods of volatility with the Federal Reserve’s actions.
The next time you read news about the Federal Reserve hiking rates, don’t be too concerned, especially if you’re considering a fixed-rate mortgage. Rates may be on the rise, but if history is an indicator, they will likely increase gradually, if at all.
The better thing to do is to compare mortgage options online to see if the Fed funds rate is having a negative effect on mortgage rates. If you’re thinking about buying, you don’t need to panic, but it’s always better to purchase a home when rates are lower so you have the lowest monthly payment possible.
If current rates are still affordable, it may be time to hop off the fence with your homebuying dilemma and lock in a current rate, so you can buy your home sooner than later.