John M. Lee: Mortgage Interest Rates

While the Federal Reserve Bank and Mr. Alan Greenspan have been aggressively decreasing interest rates this year, mortgage rates have not gone down proportionally.

Many people believe that when the fed's announce a rate reduction, the mortgage interest rate should automatically decrease. This article will examine the misconceptions in the marketplace about mortgage interest rates and what cause them to go up and down.

In the old days, mortgage interest rates were set at 5 percent fixed for 30 years. Banks would take in money from customers, pay them 2 percent interest and lend the money back out for mortgages at 5 percent, making the difference as their profit. This all worked well for the banks until rampant inflation came in.

I recall in the 1980's, during the times of double-digit inflation, I was able to get 13 percent interest on my CD deposits. All the while, the banks were only getting 5 percent interest on the money they loaned out many years previously. So they were only getting 5 percent in and they had to pay me 13 percent on the money I deposited with them, which was a money-losing proposition. This contributed to some of the banking problems in the 1980's when quite a number of banks went out of business.

To prevent situations such as these from occurring on a regular basis, which would create a mess with our banking system, organizations such as Fannie Mae and Freddie Mac were setup to create a secondary market for mortgages. They purchase mortgages from federally insured financial institutions and resell them in the form of mortgage-back securities.

Also, the banks started to promote adjustable-rate mortgages where the consumers share in the risk with the banks (they don't quite promote them this way). So when interest rates go up and the banks have to pay more for their money, the mortgage rates go up and borrowers have to pay more too, limiting the bank's exposure to potential losses.

Because lenders have learned their lesson during hard times, they have been very quick in raising mortgage interest rates and very slow in lowering them. When rumors of rate increases begin, you can bet that the mortgage interest rates will go up on the rumor. But when the fed's cut rates, the banks are slow to decrease them. Eventually, it will filter down and mortgage rates might decrease, but only to a certain extent.

What we have found is that because the mortgage is a long-term loan, the increases and decreases in rates track more closely with long-term bond yields. When the feds cut the discount rates and/or fed fund rates, they are really cutting the short-term interest rates. The discount rate is the interest rate charged by the Federal Reserve on loans made to its member banks. The fed fund rate is the rate of interest on overnight loans of excess reserves made among commercial banks. So if the Federal Reserve cuts the discount or fed fund rates, it might not necessary have an effect on the mortgage rate.

This year, the feds have cut the discount rate a total of 2.5 percent. However, the 30-year fixed-mortgage rate has dropped less. In fact, after the last fed rate cut May 15, the mortgage rate actually increased substantially.

So, let's put the mortgage rate in perspective. A 30-year fixed-rate loan is going for approximately 7 percent to 7.5 percent. Historically, this is a very low rate. The last time it was this low was in 1994 and prior to that, in the 1970's.

I still remember purchasing my first home in 1981 with a fixed-rate loan at 17 percent! And eventually, the mortgage rate went up to 21 percent and I thought I got a great rate.

So, historically speaking, the mortgage rate is low and probably won't go down too much more from here.

I recently had some buyers tell me that they are waiting for the interest rates to go down further before buying and some owners telling me that they are waiting before refinancing. Just remember that you will never be able to pick the bottom until after it happens, so I would recommend that you make a decision and go for it. And the good news is that if you are correct, and that rates do go down, there are so many no-point and no-fee refinancing options available that you can still take advantage of the lower rates at a later date.

John M. Lee specializes in selling properties in the Richmond and Sunset districts. If you have any questions regarding real estate, call him at (415) 447-6231 or e-mail him at