What Happens to the Mortgage Rates If the Federal Reserve Lowers the Interest Rates?

The interest rate that a person is offered on a home loan is affected by a number of different factors. Among these is the person's credit rating, with people with higher ratings generally being offered more favorable terms. However, all interest rates are also affected by the current rates available on the lending market. These rates are generally lower when the Federal Reserve lowers the interest rate at which banks make loans.

Federal Reserve

The Federal Reserve is the central bank that controls the supply of U.S. dollars. Through the use of open market operations, the Fed can raise and lower the amount of money available. By changing the money supply, the Fed manipulates the interest rate at which banks lend to their best customers. This is known as the prime rate and forms the basis for many other interest rates.

Lowering Interest Rates

The Fed will often choose to lower the prime rate by increasing the money supply. By making money more available, the Fed makes money more available to lenders. This causes lenders to lower the rate at which they are willing to lend to borrowers. This means that people who are looking to take out mortgages will generally be able to receive cheaper financing.

Indexes

Another way in which mortgage rates change is by changes to lending indexes. Adjustable-rate mortgages, in which the interest rate the homeowner pays on the loans changes regularly, are always linked to one or more lending indexes. As interest rates decline, the size of the payments that borrowers are required to pay on their homes will decline. So, the Fed dropping interest rates often leads to a person paying less on his current mortgage.

Long-Term Effects

While a drop in the interest rate caused by an increase in the money supply will drop interest rates in the short term, this may not happen in the long term. This is because when the money supply increases, inflation rises. As inflation rises and money becomes less valuable, lenders will generally raise the interest rate of loans to keep pace with inflation. This can lead to higher interest rates in the long term.