How Market Conditions Affect Interest Rates

by : Matt Schaub

Many people who are buying a home or refinancing are surprised to learn that, when they hear about the Federal Reserve Board lowering interest rates, mortgage rates actually go up. How can that be?

Well mainly, it's because we're talking about a different category of interest rates. The Federal Reserve Board is dealing with the Federal Funds rate. This is the interest rate at which large banks lend funds to one another in the short-term.

Mortgage rates, which can be set for up to 30 years, are long-term rates. These long-term rates respond to expectations about inflation. When those other short-term rates fall, it encourages greater buying and spending. This can cause inflation. And when there's concern about inflation, longer-term rates - mortgage interest rates, for example - can rise.

Now mortgage interest rates, which are determined daily in active public markets, are often ahead of the Federal Reserve Board. If these markets anticipate a slowdown in the economy, interest rates can fall. That's because they're expecting the Federal Reserve Board to lower short-term rates. And as you might expect, the opposite can also occur: mortgage rates can rise well ahead of an increase in short-term rates by the Federal Reserve Board.

One of the most interesting aspects of all this is that markets are acting based on how they think the Federal Reserve Board will decide about the Federal Funds rate.

It certainly can be complex! But at least a little greater understanding by consumers of some of the market dynamics just discussed can be useful in helping us all become smarter mortgage shoppers.

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