Interest Rate Roundup

Wednesday, September 19, 2007

What the Fed's rate cut does -- and doesn't -- mean for mortgages

Ask a layperson to explain what a Federal Reserve rate cut means for mortgages and you'll probably get a simple answer: They get cheaper! But the reality is a bit more complex. Depending on the type of mortgage you're talking about, the rates being charged could fall in lock step with the Fed cut ... the rates could go down by a smaller margin than the Fed cut ... or they could actually go UP. Let me try to break things down:

* Rates on home equity lines of credit (that's the P.C. term for "floating rate second mortgages) almost always follow the prime rate. And the prime rate almost almost moves in lock step with the federal funds rate. So if you have a HELOC, you're going to pay 50 basis points less in interest very soon.

* Rates on shorter-term Adjustable Rate Mortgages, such as the 1-year ARM, also tend to track movements in shorter-term Treasury rates -- not prime. So the Fed rate cut will likely make these loans cheaper for new borrowers, but the decline will likely be smaller than 50 basis points.

* What about rates on all those EXISTING ARMs we're so worried about? Well, if you're a subprime borrower with one of these 2/28 mortgages, chances are your loan adjusts to LIBOR -- the London Interbank Offered Rate. Up until recently, LIBOR rates had actually been RISING despite a decline in short-term Treasury rates. The reason: LIBOR is a rate charged between banks lending each other money, and they were worried about credit risks stemming from mortgage losses, CDO losses, and more.

But the Fed rate cut has succeeded -- at least for now -- in bringing down LIBOR rates. Six-month, U.S. dollar-based LIBOR dropped 31 basis points overnight, for instance. That leaves it at 5.11%, its lowest level since March 2006. Bottom line: People facing rate and payment adjustments will see some relief -- though not enough to prevent the current delinquency and foreclosure rates from rising further.

Other ARMs are tied to things like the 11th District Cost of Funds Index, or COFI, and the 1-year Constant Maturity Treasury Index. Treasury rates have already been falling, while COFI will likely start to decline (with a lag). Long story short, if you have an ARM and you're facing an imminent adjustment, you will probably see a smaller hike in rate and payment than you would have if the Fed didn't cut.

* Now let's get to the BAD news. The Fed's drastic cut in SHORT-TERM rates has revived LONG-TERM inflation fears. After all, the Fed is cutting the cost of money at the same time oil is trading at $82 a barrel and counting ... gold is trading at its highest level since 1980 ... agricultural commodities are soaring in price ... and world economic growth is robust, despite our housing-led downturn. That makes the Fed cut a high-risk move, one that threatens to cement these higher prices into the economy.

Long-term bondholders hate inflation. So long-term Treasury bonds are getting pounded. Long Bond futures were recently down more than a point in price today, in fact, after losing 7/32 yesterday. Since yields move in the opposite direction of prices, long-term rates are rising. The 10-year Treasury Note yield is UP 7 basis points today, after rising a smidge yesterday.

The end result: Rates on 30-year fixed rate mortgages will NOT drop 50 basis points like fed funds. In fact, they may go UP. So if you're looking to refinance out of an ARM into a FRM, don't expect to get any help from the Fed's move.

I hope this helps clarify things a bit more. This Chicago Tribune story has some more details, as does this special section from the good folks at


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