When the Fed cuts rates, do mortgage rates drop?

(photo courtesy of Boston.com)

This week, the Federal Reserve cut the “federal funds rate” from 1.5% to 1% and the “discount rate” from 1.75% to 1.25%. What does this mean? Well the federal funds rate is the rate that banks lend money to other banks overnight. The discount rate is basically the interest rate that the Federal Reserve charges banks when they borrow money from the government. So in short, a “Fed rate cut” basically makes it cheaper for banks to borrow money from each other and from the government.

There is a common misperception that when the Fed cuts rates, mortgage rates also drop. This is not necessarily the case. In fact, 30 year fixed mortgage rates have actually risen in Zillow Mortgage Marketplace since the Fed cut rates earlier this week.

Why? Well just because it’s cheaper for banks to get money doesn’t mean they pass those savings on to borrowers. Mortgage rates fluctuate based on supply and demand for mortgages — they drop when banks’ propensity to lend increases. Unfortunately, in this crazy lending environment, lower borrowing costs for banks do not necessarily translate into lower borrowing costs for mortgage holders. The one exception is loans (e.g., HELOCs) which fluctuate based on a particular rate such as the discount rate or the prime borrowing rate. Those loans do adjust when the Fed cuts rates. But on the whole, it’s a mistake to assume that when the Fed cuts rates, mortgage rates decline.

For more information about this admittedly confusing topic, check out our Discussions section on mortgages.

October 31, 2008