The Difference Between Federal Funds Rate and Mortgage Interest Rate

When buying a home or an income property, shopping for the best mortgage terms is essential.

Do you know how to compare term sheets and the difference between the Federal funds rate and your mortgage interest rate?

We’ve outlined the rates and their relationship below to help you be more knowledgeable and informed as you prepare to purchase your property.

What is the Federal Funds Rate?

Financial institutions are required to keep a minimum reserve and maintain that reserve; they routinely lend and borrow from each other overnight. The two financial institutions set and agree upon the interest rate when this transaction occurs.

The Federal Reserve does not directly set the rate at which financial institutions like banks and credit unions can borrow from each other. However, it can and does set a target rate. The federal funds rate is the average of all the interest rates between financial institutions. The Federal Reserve has tools to raise or lower this rate by impacting the economy.

What is Your Mortgage Interest Rate?

Your mortgage interest rate is the percentage of the principal that you owe in interest. Depending upon your amortization schedule, you will pay a different amount of interest each month. If you have a fixed-rate mortgage, your monthly mortgage payment total will be consistent, but the amount of interest and principal in that monthly payment will vary.

How are the Two Related?

The mortgage interest rate your lender offers you depends on several factors. Some factors are related to your finances, such as your income, employment history, debt-to-income ratio, credit score, and cash reserves.

Other factors are dependent on the economy as a whole. This is where the Federal funds rate comes into play. The speed at which your lender can borrow money will impact your mortgage interest rate. When a financial institution has to pay more to borrow money to maintain its reserve, that expense is passed on to you as the consumer.

The Bottom Line

A higher federal funds rate ripple effect results in higher mortgage interest rates. Higher expenses for financial institutions get passed on to you, as the consumer, through higher mortgage interest rates. This usually drives housing prices down as the cost of borrowing increases.

However, experts predict that in 2022 prices in the Bay Area real estate market will remain high even as we see changes to the Federal funds rate. As demand for Bay Area housing remains high, you can anticipate a seller’s market for the rest of the year. Real estate professionals do not expect to see significant seasonality in the market this year, as most homebuyers are millennials looking to purchase their first home. Demand for affordable housing will likely increase, even with a higher Federal funds rate.

As you see headlines about the Federal Reserve raising the Federal funds rate, you can reasonably expect higher mortgage interest rates. Suppose you are otherwise prepared to buy a home. In that case, this news might create a sense of urgency to get into the market at the lowest possible interest rate because even small fluctuations in interest rates may affect your budget significantly. With the right team of professionals, buying a home, even at a higher rate, is still possible.