You probably are aware that the Federal Reserve has been aggressively raising interest rates. The recent interest rate increases which began in 2022 and are continuing across 2023 are a swift reversal from the Federal Reserve’s recent decade-long policy in which they cut interest rates almost continuously. If you are wondering why the Federal Reserve has decided to reverse its policy and increase interest rates aggressively, which seems to only cause pain for the economy, the reason they are doing this is because it is one of the best tools to combat rampant inflation.
So what exactly does it mean when the Federal Reserve increases interest rates? Are they making the interest rates on your mortgages, auto loans, personal loans, and business loans all increase simultaneously? If so, is it by the same amount across the boards? Below we will cover the exact details of how the Federal Reserve increases interest rates and how it impacts you as a consumer. Be warned, it is a complex topic, but we will do our best to simplify this for you.
When the Federal Reserve decides to raise interest rates what they are actually doing is increasing the interest rate for one specific index known as the federal funds rate. The federal funds rate is the interest rate that commercial banks charge each other when borrowing or lending amongst each other overnight. Banks do this overnight lending to ensure that they meet legally mandated reserve requirements.
A higher federal funds rate means that banks are less willing to borrow amongst each other overnight because it would cost them more money in interest. This creates a ripple effect in how banks decide to operate their day-to-day business. One of the ripples that this creates, the one which we care about, is the need for banks to charge higher interest on their consumer loans. They do this to offset the increased risk that they will need to borrow at a higher rate overnight to satisfy their reserve requirements so that their profit margin can remain the same.
If that all sounds like a bunch of abstract or convoluted theory to you, all you need to do is think of the federal funds rate as a benchmark rate that indirectly affects all other interest rates. If the benchmark rate is higher than all other interest rates typically trend higher. Because it is indirect, a 0.25% increase in the federal funds rate does not necessarily mean a 0.25% increase in mortgage rates.
While the interest rates for mortgages are greatly influenced by the federal funds rate, there are some additional factors that influence mortgage rates. This includes the strength of the current economy, the inflation rate, and the overall bond market as a whole.
In general, and while it might seem backward when the overall economy (or at least expectations of the economy) is doing well mortgage interest rates tend to increase. This occurs because more people can afford higher payments, which allows lenders to increase their interest rates as demand increases. Furthermore, when the economy is hot inflation tends to increase as people spend more money on goods and services across the board. This typically causes an increase in the federal funds rate which increases all other rates. Additionally, when the prices of bonds are low, mortgage rates tend to increase. The reason for this increase in rates is that investors need extra incentive to invest in mortgage-backed securities to offset their being able to obtain a less risky investment elsewhere.
Like many other types of loans, mortgage rates are also determined by the borrower’s specific credit profile. The better your finances look on paper, and if you have proven yourself to handle debt well, the lower your interest rate will be. Additionally, the type of property you are purchasing can also play a role in interest rates. A condo often has a slightly higher rate than a single-family residence and an investment property is more expensive to finance than a primary residence.
Mortgage rates are determined by a complex combination of factors. This is often why they fluctuate so dramatically from day to day, month to month, and year to year. The federal funds rate is an important indirect measure of mortgage rates but is not the end all be all. There are other factors to consider. While understanding the intricacies of mortgage interest rates can be eye-opening, what is more important is to make sure you are getting a competitive rate given the current market conditions.