On rate cuts and mortgages

Question: We've been following the mortgage rates because we want to refinance our mortgage.

The Federal Reserve cut interest rates twice last month. The first time they cut rates, mortgage rates came down. Then the Federal Reserve cut rates again about a week later, but when we checked with our mortgage company, the rate was higher than it was after the first Fed rate cut. That doesn't make any sense.

Why would mortgage rates go up when the Fed cuts rates? We expected the mortgage rates to drop even lower.

C.B., Lynnwood



Answer: This is a common misunderstanding about how the mortgage market works.

When the Federal Reserve cut its short-term interest rates by 0.75 percent on Jan. 22, mortgage rates dropped. But when the Fed cut rates by another 0.5 percent just over a week later on Jan. 30, mortgage rates did not drop, they actually went up.

Why?

First, you have to realize that the mortgage market does not directly follow the Federal Reserve interest rates.

The Fed action only affects short-term interest rates. Mortgages are long-term investments. Sometimes mortgage rates fall along with short-term rates, but sometimes they go in the opposite direction.

The Fed typically cuts short-term interest rates to spur the economy in hopes of either preventing a recession or of helping to bring the economy out a recession.

But the Fed has to walk a tightrope, because if it cut rates too much and too fast, the economy could heat up too much and result in inflation, which is Public Enemy No. 1 to the Federal Reserve.

The reason that the first Fed rate cut on Jan. 22 caused mortgage rates to fall is because the financial markets saw it as a bold move to lower the cost of money for businesses who are trying to avoid an economic slowdown. In other words, it was intended to head off a recession.

The reason that mortgage rates did not drop following the second Fed rate cut on Jan. 30 is because some in the financial markets think that the Fed may be cutting rates too much, too fast, and they fear that may trigger inflation.

Inflation is a bad thing for mortgage investors because they are making long-term investments.

Traditionally, the interest rate on a 30-year fixed rate mortgage averages about 3 percent to 4 percent above the inflation rate. So if the inflation rate is 2 percent, the interest rate on a 30-year fixed rate mortgage would range between 5 to 6 percent.

But what if the inflation rate doubled to 4 percent? Then the mortgage investors who made 30-year fixed rate loans at 5 percent would be in big trouble!

So the mortgage market bases its rates on what it thinks the inflation rate will be in the future.

When there is concern that inflation is increasing, mortgage rates will rise -- even if short-term rates are going down.

This is very confusing to the average home buyer or homeowner, but that's how the mortgage market works.

Right now, mortgage rates are at their lowest point since the summer of 2005.

We are in a very volatile time in the financial markets. The stock market has dropped dramatically, but there have also been some very big "up" days. Mortgage rates fell after the first Fed rate cut last month, but now they are ticking up again.

If you are thinking about refinancing and waiting for more Fed rate cuts or trying to hit the absolute "bottom" of the mortgage rates, you may miss out.

If you can get a mortgage rate that saves you a lot of money today, you are probably better off taking the sure thing rather than waiting for something better next week or next month, because even if the Fed cuts short-term rates again, mortgage rates may actually move up.

Mail questions to Steve Tytler, The Herald, P.O. Box 930, Everett, WA 98206 or e-mail to economy @heraldnet.com.