What the Fed’s rate increase means for mortgage rates

For the first time since before the introduction of the iPhone the Federal Reserve (Fed) members voted to increase the target rate for federal funds (FF). The increase is 1/4% and was widely expected. What does this mean for mortgage rates? The key is to understand which rates are impacted by the Fed Funds rate and which are dependent upon interest rates set by the market.

Which rates are based upon the Fed Funds rate?
30 year fixed rate mortgages (FRN) are not based on the FF rate, but are most closely tied to the yield on 10 year US Treasuries(10T). More on that in a minute.

The prime rate directly follows the FF rate, is set by banks and is consistently at a margin of 3% above the FF rate. Immediately after the increase in the FF rate, all the major banks raised their prime rates from 3.25% to 3.5%. The chart below (which is before this week’s increase) confirms that FF and prime rate move in lockstep.

Interest rates which follow prime rate are home equity lines of credit (HELOC), credit cards and auto loans. The only direct property-related impact is on HELOCs. Note the difference between home equity loans – which are for a fixed amount at a fixed interest rate – and HELOCs, which are for a varying amount at an interest rate which varies with the prime rate. The interest rate on a HELOC is normally stated as “prime plus (or minus) x per cent”, so the interest rate on these will increase immediately.

Fixed Rate Mortgages
FRM rates are set by individual banks and are dictated by market conditions. Since most traditional mortgages are sold to investors in the form of mortgage-backed securities, the yield demanded by investors is most closely linked to the yield on US Treasury 10 year Notes (10T). The yield on 10T is often seen as an indication of the strength of the US economy, although the yield can also be influenced by macro-economic factors such as a flight to safety which occurs in times of uncertainty.

So what happened to the 10T yield this week after the FF increase on December 16?

A short spike and then back to where it was. Thus, the FF rate increase had little or no affect on fixed rate mortgage rates.

Will mortgage rates increase in 2016?
Yes – probably. The Fed is expecting to increase short-term rates 3 times in 2016 as the economy expands and inflation starts to pick up. If the Fed is right it is likely that the yield on the key 10 year Treasury will increase and it is that which will lead to higher fixed rate mortgage rates.

What could happen to cause mortgage rates not to rise?
Quite a lot actually. If commodity prices remain weak, there will be a significant deflationary impact felt in several countries; China’s slowdown could continue to be a drag; and of course there is always the risk of a major war or confrontation.
The US economy is doing quite well, but will not be immune to what is happening elsewhere in the world.

4% mortgages are cheap
The guessing game – or forecasting, as economists like to describe it – of what will happen in 2016 should not disguise the basic fact that mortgage rates today are cheap – and may not be as cheap in the months and years ahead.

Adjustable Rate Mortgages (ARM)
ARMs are priced at a margin in addition to a certain index, often the 1 year Treasury yield or 1 year LIBOR (London Inter-Bank Offered Rate). Yields here have been increasing steadily this year as shown below:

These yields are of the first of each month, and by Friday the yields were 1.05% for LIBOR and 0.67% for the 1 year Treasury, so both have increased about 0.4% this year. As ARMs typically have the rate fixed for the first 5 years, anybody who has taken out an ARM in the last few years will not have seen an increase yet, but older ARMs have and others will see increases when the fixed rate period ends. And as can be seen from the chart, new ARMs are likely to be more expensive than in the past.

ARMs can be a useful tool in overall financial planning, but anybody taking out an ARM today should consult her financial advisor to understand the implications down the road.

If you – or somebody you know – are considering buying or selling a home and have questions about the market and/or current home prices, feel free to contact me on 617.834.8205 or Andrew.Oliver@SothebysRealty.com.

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Andrew Oliver is a Realtor with Harborside Sotheby’s International Realty. Each Office Is Independently Owned and Operated

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