Why the Discount Rate Matters

If you’re shopping for a mortgage and are curious about the factors that affect interest rates, you might want to read more about the so-called “discount rate.” The discount rate doesn’t directly determine the interest rate you’ll likely pay on your mortgage, but there is a clear long-term correlation between the discount rate and mortgage rates.

What is the Discount Rate?
The discount rate is simply the interest rate that the Federal Reserve charges commercial banks on the loans they get from the Federal Reserve’s “discount window.” In other words, if a bank wants to borrow money from the Fed, the discount rate will be charged. It’s important to remember that banks, not consumers, borrow money from the Fed and pay the discount rate. Most loans to banks at the discount window are very short-term, even just overnight.

The discount rate is an “administered rate,” which means the rate is set by the Federal Reserve. The Fed doesn’t set the rate on consumer loans or mortgages. Instead, those are “market rates,” which means each rate is set by open-market competition among lenders.

Discount Rate mirrors mortgage rates
The Fed adjusts the discount rate from time to time depending on what’s happening in the economy. When the Fed makes those adjustments, interest rates on Treasury notes and other short-term loans might be affected by the change in the discount rate. Interest rates on mortgages may also be affected when the Fed raises or lowers the discount rate, but the effect of the discount rate on mortgage rates is not as strong as the effect of the discount rate on shorter term loans.

The discount rate and mortgage rates tend to track along the same trend lines; however, these two rates can divide and take separate paths at times since they aren’t directly connected. In other words, the ups and downs of mortgage rates tend to follow the fluctuations in the discount rate, but that correlation isn’t always a sure thing. In 2001, for instance, the Fed cut the discount rate to 1.25 percent, but the average rate on a 30-year fixed-rate mortgage didn’t decline that much during that year.

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