3 Things You Should Know About the Fed and Your Mortgage
What does “Quantitative Easing” or “Operation Twist” have to do with mortgage rates? What do you have to know about these policies taken by the Federal Reserve during the recent recession — as well as other actions the central bank may take — when thinking about buying a home or refinancing a mortgage?
Don’t worry, you don’t have to be a Fed Watcher to decide when to take out or refinance a home loan. While the central bank’s control over the benchmark U.S. interest rate means that its actions have a big impact on mortgage rates, there’s one basic rule to keep in mind when making any home financing decisions, says Doug Duncan, senior vice president and chief economist at Fannie Mae.
“The rule for when is it time to refinance or buy is always the same: given your household budget and where current interest rates are, if it makes good financial sense to refinance or take out a home loan today, then today is the day to do it,” explains Duncan.
If you catch yourself trying to guess which way mortgage rates are headed in deciding when to pull the trigger, you’re heading down the slippery slope toward speculation. “If you’re hoping that interest rates will fall — given how hard it is to predict them — you have moved from being a homeowner making a financial decision to becoming a speculator,” he says. “And you have to answer the question, `Can I afford to be a speculator?’”
That doesn’t mean it doesn’t pay to understand how the Fed’s actions can impact mortgage rates. After all, Fed Chair Janet Yellen and her fellow central bankers have a big say in how much you’ll be paying for what could be the biggest investment of your life.
So here are a few things to keep in mind when tuning into C-SPAN with a bowl of popcorn to watch Yellen get grilled by lawmakers:
1. Mortgage Rates are Tough to Predict
A whole cottage industry is devoted to hanging on Yellen’s every word and gesture to try to divine what the Fed is planning to do. But economists will be the first to acknowledge that it’s very difficult to foresee the future path of interest rates.
“The first thing to know about interest rates is that they are notoriously hard to predict,” says Duncan. “I’m a professional forecaster, and I’ll tell you, I get it wrong too.”
What gives? The fact is, there are innumerable variables involved in determining interest rates.
The first thing to understand is that U.S. mortgage rates move in line with U.S. Treasuries — debt issued by the U.S. government. The Treasury market is the biggest in the world, with $12.5 trillion held globally by investors. So things happening elsewhere in the world — whether it’s actions taken by the European Central Bank or concerns about a slowdown in China — can impact Treasury rates.
Add to that another layer of factors specific to the mortgage market — from the state of the housing recovery to basic supply and demand of home loans — and you get the point: mortgage rates go up and down every day for any number of reasons.
2. Fixed-Rate and Adjustable-Rate Mortgages Dance to Different Beats
To further complicate matters, which Treasury rate to watch depends on the type of mortgage you’re interested in — whether it has a fixed or adjustable rate.
With an adjustable-rate mortgage, the interest rate is reset after a specific period of years, based on where interest rates are at that time. Thus, they move more in line with shorter-term Treasuries.
The main way the Fed influences interest rates is by raising or lowering a benchmark rate — called the Fed Funds Rate — that banks use when lending to each other overnight. Given its very short-term nature, changes in that rate by the Fed have more effect on adjustable-rate mortgages.
“When the Fed raises interest rates, the most immediate impact in the mortgage market that a consumer would see would be an increase in interest rates on adjustable-rate mortgages,” says Duncan.
Meanwhile, traditional fixed-rate, 30-year mortgages are more influenced by what’s happening with longer-term Treasuries. While the most obvious place to look would be the 30-year Treasury rate, fixed-rate mortgages are actually more closely linked to 10-year Treasuries — given the fact that homeowners often sell or refinance well before the 30 years is up.
“People tend to prepay their mortgages in an eight- or nine-year time frame because they move or something else happens,” he explains.
So how does the Fed impact longer-term rates? By setting expectations about where it sees the economy going in the long run. For example, a hike in short-term rates won’t necessarily lead to a similar increase in long-term Treasuries if the Fed is forecasting relatively weak U.S. economic growth.
“If the Fed raising the short-term rate is a signal that it’s because the economy is strengthening. That usually indicates that they expect longer-term interest rates to go up, as well,” says Duncan. “Though that’s not always the case.”
3. Volatility is the Name of the Game
Indeed, that initially appeared to be the signal that was given by Yellen and her colleagues when they took the significant step during their latest meeting of dropping a pledge to be “patient” about raising rates. The central bank has kept the Fed Funds Rate in a range of between 0 percent and 0.25 percent since 2008, as part of its unprecedented efforts to address the global financial crisis.
Yet while suggesting the Fed was moving closer to raising the rate, Yellen cautioned: “Just because we removed the word patient from the statement, doesn’t mean we’re going to be impatient.”
In reaction, mortgage rates actually fell — instead of rising, as some expected — after the Fed meeting. “They’re going to raise short-term interest rates at some point,” says Duncan. “But that doesn’t necessarily mean it’s going to happen very fast.”
In other words, it’s hard to predict what the Fed is going to do, let alone what interest rates will do. Duncan anticipates a rate hike in September, while the expectations of other economists range from June to sometime next year.
In the meantime, they’ll be looking for clues about everything from the housing and jobs markets to inflation and what’s happening overseas — while keeping tabs on what Fed officials have to say.
“I would just be listening for the tone of their comments,” says Duncan. “They may at some point come out and say something explicitly, but that would be unusual.”
Thus, he says, here’s the only prediction about interest rates that would be an easy call: “As they reverse their policy, you should expect there will be more volatility.”
Which brings us back to the original rule of shopping for a home loan: Take out a mortgage when it makes sense for your own budget.