30 Year Mortgage Rates Not Tied To Fed Funds Rate

Author: Rob K. Blake | Date: October 8, 2008 | Filed In: Mortgage Rates

Consumers expect 30 year mortgage rates to drop when they hear in the media the Fed cut interest rates. However, the rate the Fed cuts is the Fed Funds Rate which has nothing directly to do with mortgage rates.

30 Year Mortgage Rates vs. Fed Funds Rate

The media reports a rate cut and all mortgage holders or home buyers are feverishly out searching for the impact on the most common mortgage program, the 30 year mortgage.

This very rarely happens…and here’s why.

The Fed Funds rate is the rate commercial banks can borrow money from the Fed. It is a short term lending rate, so it has impact on short term bank lending. For consumers this means any credit cards, car loans, or lines of credit could see an impact to the rate as commercial banks pass through this short term rate by adjusting their Prime Rate.

Long term rates, like 30 year mortgage rates, are not effected directly in this way.

Long term mortgage rates are an outgrowth of what’s happening in the bond markets. Meaning mortgage rates ebb and flow with the yields established on longer term investments like the 10 year bond. And sadly, even that is not 100 percent correlated, but it’s the best comparative measure we have.

Think of it like this…

A 10 year bond and a 30 year mortgage (which historically pays off in 7 years) are close in duration, and the Fannie Mae/Freddie Mac version of a mortgage both have the full faith of the government standing behind them. So if you are an institutional investor ( ie. pension fund, hedge fund, insurance company) with ton of cash to invest, you can buy 10 year Treasury bonds or mortgage backed securities which are backed by 30 year fixed rate mortgages.

Since these two investment options compete against one another for investor favor…their yields/rates are tied. The mortgage yield/rate is always slightly higher to offset other risks still inherent in mortgages.

Remember from an investor perspective “rate” is called “yield”, so as an investor you are looking for the better/higher yielding investment. From a consumer standpoint since you are the one paying the yield, you call it rate, and are looking for the opposite.

For 30 year mortgage rates to drop, the competing yield on the 10 year bond has to drop.

As a consumer if you want to know where 30 year mortgage rates are headed, you must not listen to Fed Funds rate cut announcements, but look at what the bond market is doing. When the yield on the 10 year drops, most likely 30 year mortgage rates will soon follow.

Good Luck!

PS: To get a deeper explaination of the competing investment theory, check out our post, Current Mortgage Interest Rates: Why They Rose After The Fed Cut.

PPS: If you are mortgage shopper looking for the best 30 year mortgage rate, read, 30 Year Mortgage Rate - Who Is Telling The Truth?

Author: Rob K. Blake