It is a common myth that the Federal Reserve directly sets mortgage rates. In fact the Federal Funds interest rate is the overnight borrowing rate that banks charge each other to borrow money for one day for the use of government money. The Federal Reserve raises this rate by withdrawing cash from the banking system, therefore it does not directly set the value.

To understand the relationship between the Federal Funds interest rate and mortgage interest rates, you must understand the difference between short-term and long-term interest rates. The Federal Reserve has tight control over the short-term interest rate but not the long-term rate.

The long-term interest rate is broadly defined as the rate offered on U.S. Treasury securities that mature in 10 to 30 years. Mortgage rates are largely determined by long-term interest rates, most commonly identified as the ten-year U.S. Treasury bond.  (The ten-year bond has replaced the thirty-year security as the benchmark due to trading volume.)

So who really controls mortgage rates? The short answer involves investors who buy bonds in the two major corporations that buy home mortgages, Fannie Mae and Freddie Mac. These two corporations make money by selling bonds and using the proceeds to buy mortgages, which pay them a higher rate of interest than they are paying to their bondholders.

The mortgage rate will always be higher than the bond interest rate because Fannie Mae and Freddie Mac want to make a profit.  And the bond interest rate will always be higher than the expected rate of inflation because bond investors always want to beat inflation.

Mortgage interest rates are based on the yields of Mortgage Backed Securities or Mortgage Bonds. These bonds are bought and sold daily by large investors. Bond prices, just like stocks, fluctuate by the minute. Mortgage professionals like to see bond prices rising. If your mortgage person states that rates are based on Fed Funds rates, i.e. the Prime Rate or Treasury rates, they are dead wrong and this should be a cause for concern.

Bond Markets are concerned with the pace of economic growth and inflation, generally speaking mortgage bonds move opposite the stock market. So as the stock market improves, mortgage bonds generally drop in price (bad for interest rates). Probably the most important report is the Employment Report issued on the first Friday of every month by the Bureau of Labor Statistics. Stronger than expected employment growth would be bad for interest rates. A second report may be the Consumer Price Index issued monthly by the Bureau of Labor Statistics. Again, strong economic growth shifts money out of the bond market into stocks. This shift would cause bond prices to drop (bad for interest rates!).

The Federal Reserve Bank only controls the Discount Rate and the Fed Funds Rate, components of the Prime Interest Rate. 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. Again, the mortgage bond market controls mortgage interest rates. In fact, very often mortgage rates travel in the opposite direction of the Prime Rate. A bonus question: What about HELOCs?That's a different story. Home Equity Lines of Credit are usually based on the Prime Index Rate. So, their interest rate goes up with the Prime Rate. This extra bit of knowledge could be very important.

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