Fed Rate Cuts Don’t Necessarily Mean Lower Mortgage Rates

So the Fed cuts rates another 0.75%. Is a Fed rate cut really good news for mortgage rates? The facts may be surprising. The Federal Reserve can only control the Fed Funds Rate and the Discount Rate. The Fed Funds Rate is the rate at which banks can borrow money from one another on an overnight basis. The Discount Rate, on the other hand, is the rate at which banks can borrow money directly from the Fed on an overnight basis (now a 30 day basis). This is very different from mortgage rates.

A mortgage rate can be in effect for 30 years. A rate that is set by the Fed can change from one day to another. This is a counter-intuitive relationship for most people because when they hear that the Fed is lowering rates, they instinctively think it means mortgage rates.

The Federal Reserve uses the Fed Funds Rate and the Discount Rate to both stimulate and slow down the economy. The Fed watches trends in new jobs, new unemployment filings, worker productivity, wages, housing, both resale and new construction, and inflation at the consumer and producer level.

The Federal Reserve is trying to maintain a “healthy” economy. If the economy is growing too fast the Fed will raise rates to slow down economic growth. If the economy is slowing down, as it is currently, the Fed will cut rates, and sometimes aggressively, in an attempt to stimulate economic growth.

So what are mortgage rates based on? The answer is mortgage-backed bonds known as Mortgage-Backed Securities (MBS). How these bonds issued by Fannie Mae and Freddie Mac perform will determine the direction of mortgage rates.

It is not necessarily what the Fed does that affects mortgage rates, it’s how the Nasdaq and the broader stock market interprets the Fed’s action and policy statement that will ultimately influence the direction of mortgage rates. This is because money managers and mutual fund companies typically keep funds in either stocks or bonds with very little in cash. If stocks are in favor, money is pulled from bonds, causing bond prices to drop and interest rates to rise. When stocks are being sold off, the money is then parked into bonds, which improves bond prices and causes interest rates to decline.

If the Fed Funds Rate and mortgage rates were truly related, the chart shown here wouldn’t show them going in opposite directions – all three lines would move in tandem.

Fed rate cuts can fuel inflation, because lower rates just serve to make it more attractive to buy and finance goods and services. If the economy grows too fast, as has been the case for the last five or so years, inflation can become a problem for the consumer (you and me).

The Federal Reserve is doing all it can to keep this country from going into a recession. While the Fed normally seeks a balance between economic growth and inflation, in this case the Fed has essentially decided to sacrifice inflation to save the economy. That is not to say that the Fed is turning a blind eye to inflation. They are just focusing more attention on keeping the economy from slipping into a recession. There is a concern about the possibility of Stagflation. Those who remember Nixon remember Stagflation. This is a situation where the economy stalls and inflation rises simultaneously. In other words, people are losing jobs, making less money, and spending more to buy the basic necessities of life because of inflation.

I wouldn’t want to be Ben Bernanke is these trying times. To summarize, Fed rate cuts do not necessarily equal lower mortgage rates. There are a variety of factors that influence mortgage rates and it is important for people to know that so they don't wait for the next Fed rate cut to refinance or purchase and miss the boat because what they thought to be true turned out not to be.

Want To Be More Conservative With Your Mortgage Financing? Make A Smaller Downpayment!

Equity investments (a.k.a. downpayments) in Real Estate earn a 0% Return On Investment (ROI). Surprised? Well, let's understand the math: Assuming a 5% annual rate of appreciation, a home purchased for $400,000 will appreciate to $420,000 in one year. If the homeowner originally invested $80,000, or 20%, theoretically, the ROI is 25%. This is true because it appears that the initial $80,000 downpayment yielded $20,000 in equity appreciation. However, it is important to note that the $80,000 had nothing to do with the $20,000 appreciation.

If the homeowner had not invested the $80,000, the home would still be worth $420,000 in one year. In this instance, the ROI is infinite because the homeowner invested nothing and yet received the same $20,000 in appreciation. However, we must take into account that the rate of borrowing will be higher in this example because there is no downpayment.

Using a 7.00% Home Equity Line of Credit (HELOC) to finance the $80,000, the payment will be $5,600 in Year 1. The second example yields a return of at least 357% because the $5,600 additional payment yielded the $20,000 in appreciation.

There are other ROI considerations for the homeowner. A home is a non-liquid asset, meaning that once the homebuyer's money is invested in the home, there is a real cost to extracting the money as cash.

The initial $80,000 investment, therefore, is "lost" -- tied up in equity until the homebuyer sells, refinances, or takes out a HELOC.

Not only is the initial $80,000 investment earning 0% return for the homeowner, it is unavailable for other investments which could be earning 2% as a Money Market Mutual Fund, 5% as a Certificate of Deposit, or even higher returns with other instruments.

Therefore, the opportunity cost of making a downpayment is further depleting ROI for homeowners.

A "conservative" person will read this argument and say, "That's too risky. I am too conservative to make small downpayment."

I can buy that argument, but those two sentences are not related at all.

A true "conservative" person will recognize that the smaller the amount of downpayment, the larger the risk that the bank is taking. As the homebuyer's downpayment shrinks, so does his personal exposure.

"What if the property depreciates! Then I'll be exposed!" they'll say next.

That's true, but if the property depreciates, there is no advantage to your initial equity investment anyway. I'm sorry, but Out of sight, Out of mind is no way to manage your equity investments and finances.

The reality is the conservative financing option is to make smaller downpayments. In doing so, you push risk to a third party -- the bank! -- and you remain very liquid.

Liquidity is the true goal of a conservative investor.

I am not arguing against making downpayments on properties, for the record. But, for people who claim that Real Estate is an investment, they should treat it as such. This is consistent with my philosophy that a mortgage should be one component of a larger (managed) financial plan.

The advantages to making an equity investment in property is that the resultant monthly mortgage payment is lower. If a homebuyer's monthly cash flow is low, but their investment capital is high, there is an argument for putting 20% or even more into the property. There is also tremendous psychological inertia to overcome with respect to putting less than 20% into a property. Some people just won't hear it any other way.

That's fine -- different strokes for different folks!

Okay, with all of this said, there is actually a return on the equity investment. That return is the money saved by not paying interest on the higher loan amount if no downpayment is made. That means that the homebuyer saved an amount equal to the interest rate on the loan, or 7.00% in this case. So which is the more conservative strategy; 1) Investing a large downpayment to secure a lower monthly mortgage payment, leaving little money in reserves, or 2) Investing very little or no downpayment, paying a slightly higher monthly mortgage payment and leaving a large reserve to cover the increased payment as well as life's inevitable unscheduled emergencies?