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How Does the Federal Reserve Influence Interest Rates?
On Sept. 18, 2024, the Federal Reserve cut its federal funds rate by 50 basis points, a factor that directly impacts potential homebuyers' mortgage costs.
The Federal Reserve’s key interest rate, known as the federal funds rate, influences borrowing costs for credit cards and loans.
A recent half-point rate cut may reduce monthly loan payments, but small savings can accumulate, especially if you have multiple debts.
Additionally, many traders expect further cuts, likely dropping to 4-4.75% by December, according to the CME FedWatch Tool.
These rate cuts can offer financial relief over time as borrowing becomes less expensive.
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What is the Federal Reserve?
The Federal Reserve System, often called "the Fed," is the U.S. central bank. Established in 1913, its goal is to promote a safe and sound monetary and financial system for our nation (https://www.federalreserve.gov/aboutthefed.htm).
One of its primary functions is promulgating monetary policy, and adjusting the target federal funds rate, which affects interest rates, inflation and unemployment rates.
By adjusting the target federal funds rate, the Fed can stimulate borrowing and investment or cool down an overheating economy.
When inflation is high, for example, the Fed typically raises the target fed funds rate to temper spending and borrowing.
Conversely, the Fed lowers the target rate during an economic slowdown to encourage borrowing and spur growth.
What are interest rates?
Interest rates represent the cost of borrowing money. For homebuyers, this rate determines how much you’ll pay in interest on your mortgage.
For example, on a 30-year fixed rate mortgage, each ¼% change in the interest rate results in a $30 change in the monthly payment. Lower interest rates reduce borrowing costs, making home loans more affordable.
On the other hand, higher rates increase the overall cost of a mortgage.
Understanding how these rates are set and fluctuate is essential for making informed home-financing decisions.
How does the Federal Reserve influence interest rates?
The Fed doesn’t directly set mortgage interest rates but heavily influences them by controlling the federal funds rate—the interest rate banks charge each other for overnight loans.
Let’s look at how it works.
Adjusting the federal funds rate
The Federal Open Market Committee (FOMC), a branch of the Fed, meets regularly to decide whether to lower or raise the target federal funds rate.
For example, the September rate cut was aimed at stimulating economic activity by lowering borrowing costs for banks, which often leads to lower mortgage rates for consumers.
Impact on mortgage rates
Your direct mortgage rates are determined by factors like credit scores and lender policies, but they also often follow the direction of the federal funds rate.
When the Fed lowers rates, as on Sept. 18 this year, banks can borrow money more cheaply, allowing them to offer lower mortgage rates to homebuyers like you.
Market expectations
Sometimes, mortgage rates adjust based on market anticipation of Fed decisions.
If the market anticipates the Fed will raise rates, mortgage rates may rise even before the Fed makes its move.
Similarly, rate cuts may lower mortgage rates in advance of an official decision.
The relationship between inflation and interest rates
Inflation plays a critical role in the Fed's decision-making process regarding the target fed funds rate.
When inflation rises, money loses value, meaning it can buy less than before, while the cost of goods and services increases, eroding purchasing power.
To help control inflation, the Fed may raise the target federal funds rate, making borrowing more expensive and reducing the money supply.
In contrast, low inflation often prompts the Fed to lower the target fed funds rate to encourage spending and investment.
For potential homebuyers, understanding the relationship between inflation and interest rates is essential, as inflation trends can significantly affect mortgage costs.
Quantitative easing and tightening
The Fed also uses tools like quantitative easing (QE) and quantitative tightening (QT) to achieve its monetary policy.
Quantitative easing
The Federal Reserve purchases large amounts of Treasury securities and mortgage-backed securities issued by government-sponsored enterprises and federal agencies.
This increases the money supply, driving down long-term interest rates, and aims to stimulate borrowing and investment in the economy.
This practice was notably used during 2008 during the financial crisis—and again in the wake of the COVID-19 pandemic to stimulate economic activity.
Quantitative tightening
The opposite strategy involves selling these assets to reduce the money supply and raise interest rates.
For homebuyers, periods of QE often coincide with lower mortgage rates, making it a favorable time to borrow or refinance.
Why does this matter for homebuyers?
For potential homebuyers, changes in the federal funds rate directly impact mortgage affordability.
This recent rate cut, for example, can reduce the monthly mortgage payments amount you would secure with a new loan.
On the other hand, rate hikes make mortgages more expensive, which can slow housing market activity and reduce home prices.
When rates are high, prices tend to offset the increased borrowing costs, and the mortgage can be refinanced at a lower rate when rates fall, resulting in lower overall mortgage costs over the long term. There is no better time to borrow than now!
The impact of Fed decisions on refinancing
Fed rate changes don’t only affect new homebuyers; they also impact current homeowners considering refinancing.
A lower federal funds rate means refinancing your existing mortgage at a lower interest rate may be possible—potentially saving thousands of dollars over the life of the loan.
In contrast, if rates rise, refinancing becomes less attractive as future savings decrease.
Keeping track of Fed decisions and market trends can help homeowners better understand the decision to refinance and ensure they get the most favorable terms.
Is now a good time to apply for a mortgage?
The Fed’s September rate cut highlights a potential opportunity for homebuyers.
When the Fed lowers the target fed funds rate, mortgage rates often follow, making it an ideal time to apply for a new mortgage loan or refinance an existing one.
However, as we mentioned above, factors such as your credit score, the type of loan you choose, and broader economic conditions also play significant roles in determining your final rate.
Partnering with a trusted lender like MIDFLORIDA ensures you get tailored advice on the best mortgage options for your financial situation.
Start your mortgage application with MIDFLORIDA
Understanding how the Federal Reserve influences interest rates is key to making informed decisions about your mortgage.
Whether you’re thinking about purchasing a home or refinancing your current loan, keeping an eye on Fed rate decisions can help you lock in favorable terms and save money.
