9/20/2007

Yesterday, the Fed, for the first time in 4 years, made the decision to reduce the federal funds rate by a significant .5%. Prior to yesterday, the rate was 5.25%, and today it stands at 4.75%. This was a highly anticipated, positive step forward as the Fed admitted what many already knew, the general economy is showing signs of a slowdown, and inflation is no longer the #1 monetary issue.
 
The federal funds rate is what banks charge each other to borrow money. It is connected to many key mortgage indices, including two of the most popular: prime rate and the libor. Because all home equity lines of credit are tied to prime rate, everyone with a home equity line will immediately realize an interest rate improvement. Also, most adjustable rate mortgages are tied to the libor index, and additionally, ARM mortgage holders will benefit. Keep in mind that most ARMs have an initial fixed rate period. This will not change. However, if your ARM is currently adjusting, or set to adjust, it will not adjust as high. It is important to understand that the rate on your ARM is equal to an index plus a margin. The margin is fixed, but the index adjusts with the market, and more than likely your index adjusted lower yesterday.

Unfortunately, this rate cut does not mean that interest rates in general decreased by .5%. In fact, the reason why 30 year fixed rates saw very little improvement was because many financial institutions; lenders and banks, priced their loans better weeks ago in anticipation of this outcome. But most importantly, the Fed’s decision restored investor confidence in the economy, and as a result the stock market soared and bonds faired average yesterday. Remember that a good economy is typically bad news for mortgage rates.

The Fed does not set interest rates, markets set interest rates. What the Fed did was inject money into the system in an effort to help ease the housing credit crunch, lower consumer rates, and forestall a potential economic downturn. Questions still remain as to whether it will be enough, or whether this decision came too late, as our country battles the worst housing slump in 16 years.

Despite little movement yesterday, long term interest rates (30 year fixed rates, in particular) are declining, and may continue to do so during the remainder of 2007. The Fed stepped in yesterday, and may react again at the next meeting. But if rates lower further, it will be because the economy continues to show signs of weakness. We are now entering the 4th quarter of the year, which is historically a low for home sales and consumer spending, and perhaps yesterday's surge in the stock market was unwarranted. If this downturn continues, I foresee a window of opportunity for homeowners to refinance out of adjustable rate mortgage, and into low fixed rate loans. This comes as a welcome piece of good news, as the mortgage markets face unprecedented times.