A Primer on Rates: Federal Funds Rate, Discount Rates, Prime Rates
For the purposes of stemming inflation, the government keeps a reign on three kinds of rates: the federal funds rate, discount rates, and prime rates. All three of these rates have a direct relationship to the current state of home loan interest rates.
Although many factors affect the state of mortgages, monitoring these three rates will give you an accurate, if incomplete, picture of where mortgages are now. They are not a direct barometer, but they have a reliable impact on where mortgages are going.
Understanding the Federal Funds Rate
The federal funds rate is the rate banks charge for lending immediately available funds to another institution overnight. Basically, it’s the rate banks charge each other for lending in order to maintain their minimum reserves, and it’s maintained by the government, who uses it to control the supply of funds – borrowing and spending – and speed up or slow down the economy as they see fit. This rate is the most powerful tool in the government’s arsenal.
If the federal funds rate is higher and banks are paying more to borrow, it stands to reason that banks would charge their customers more to borrow, too. A high federal funds rate generally means higher mortgages.
Discount Rates to Banks and Other Institutions
Also called the “primary credit discount rate.” The Federal Reserve offers this to banks and depository institutions whose reserves are in danger – in other words, banks whose reserves are about to dip under the required minimum reserve amount and need to borrow money to meet the minimum. Depending on the bank’s financial standing, they will be offered a primary, secondary, or seasonal loan (in descending order of rate charged). Though banks will generally borrow from each other, the discount rate does affect the market because it controls how much money is available.
How do discount rates affect home loan interest rates? Well, if the discount rate is high, the mortgage rate will be high. Discount rates also share a relationship with the prime rate; if the discount rate goes up, the prime rate will as well, which isn’t good news for the housing market. But, if the discount rate goes down, the prime rate will follow, meaning a more robust market.
Prime Rates for the Consumer
The prime rate, despite its relationship to the discount rate, is a rate associated with commercial banks; though prime rates depend largely on the bank in question, they will still go up and down predictably in accordance with the state of the discount rate.
The prime rate is the rate charged to customers in excellent standing, the most valued and credit-worthy; customers that represent the least risk of default to the banks (typically corporations). It is related to mortgages because it is used as the basis for home loan interest rates. Home owners are often offered an interest rate advertised at more or less than the prime rate.
Prime rates are also related to the federal funds rates. The federal funds rate helps determine the prime rate, since the federal funds rate determines the amount of funds that are available.
The interplay between these three rates is important, but remember that the market will also determine where mortgage rates are going. Interest is determined by a matrix of factors. Let the professionals at Home Loans Today help you understand more about rates and which home loan is right for you.