What Happens to Mortgages When "The Fed" Raises Interest Rates?

If you've been reading or watching the financial news lately, you've probably noticed the avalanche of speculation about the Federal Reserve's next move -- triggered by the removal of a single word from its policy. That word was "patient" and that one tiny change spawned headlines like Fed removes 'patient': Prepare for interest rate hike (CNNMoney).

The Fed Does Not "Raise" Rates

But is the rate-hike hysteria justified? What does it do to mortgages when the Fed raises rates?

To find out, you must first understand that the Fed does not just order everyone to charge higher interest rates and the next thing you know, your credit card and mortgage payments go up. There is no law on the planet that allows it to do this.

One of the ways the Fed tries to keep the US economy stable and safe is with monetary policy. The simplest explanation for monetary policy is that when the economy grows too fast, inflation can take over, and that destabilizes markets and discourage people from saving. Inflation happens when you have a finite amount of resources everyone wants, for example, bacon. If the incomes, bank accounts and appetites of all the bacon consumers increase, but there is still the same amount of bacon available, its price will go up. And if that happens quickly, it can trigger bacon hoarding, runs on banks as bacon-addicts empty their checkbooks to buy bacon before it gets even more expensive…instability in an economy is a bad thing, and that's what central banks try to avert.

To control inflation, then, the Fed finds ways to restrict the amount of money available.

What DOES the Fed Do?

Here's what the Fed might do lower the supply of money and keep the bacon supply affordable.

  • It can increase the amount of money banks are required to keep "in reserve," which makes it unavailable for loans to consumers or companies. These reserve funds are lodged with the Federal Reserve (now you know how it gets its name). When banks need short-term cash to cover their operating needs, the Fed allows them to lend these reserves to each other at what's called the "Federal Funds Rate."
  • By increasing the Federal Funds Rate, the Fed indirectly increases interest rates because when lenders have to pay more for money, they have to charge more for money. More expensive money leads to less borrowing, which slows down purchasing, which releases inflationary pressure.

What Does that Do to Mortgage Rates?

Most experts would argue, "Not much." The chart below shows both the Federal Funds rate over time and the 30-year mortgage rate average from Freddie Mac's weekly survey. There doesn't appear to be a whole lot of correlation between the two.

fed rates versus mortgage rates

Why You Should Still Consider Refinancing

Even if Janet Yellen can't up mortgage rates with a click of a mouse, you should still consider refinancing. Even if they don't predict the exact timing for an increase, it's pretty much a given that rates will come up eventually. Economies are cyclical, and this cycle is showing every sign of coming to an end. When that happens, whether it takes place in June 2015, December 2015 or early next year, interest rates, including mortgage rates, will increase.

Here are a few fun facts about mortgage rates, courtesy of LendingTree contributor Gerard Anthony:

Largest increase in a single year: The biggest annual mortgage rate rise took place in 1980, and borrowers were shocked by a 5.83 percent jump in a 12-month period. A similar spike would put rates over 9.5 percent by March 2016.

Biggest one-year drop: While this is unlikely to happen, given how low today's rates are, it's fun to contemplate rates dropping by 4.56 percent. Not happening today unless we can find a way to make banks pay us for borrowing.

Average annual change: The average change for rates year-over-year, up or down, is 0.89 percent.

That could put rates next year at near five percent.

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