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Interest Rates

Posted by  on Apr 16, 2009
 
The federal funds rate, also known as the “fed funds” rate, is the interest rate charged when banks lend funds to one another. This is a short-term rate, or a rate that is two years or less in maturity. When Bernanke raises or lowers the fed funds rate, it affects mortgage rates that are tied to short-term interest rates, such as home equity rates and adjustable rates. When short-term rates fall, borrowing and spending usually increase. This can cause inflation, something the Federal Reserve wants to keep in control.

Long-term interest rates, or rates that are 10 years or more in maturity such as for 30-year mortgages, are influenced by short-term rates in a roundabout way because they can rise when concerns about inflation increase. To keep inflation under control, the Fed started raising short-term interest rates in 2004. Because of this, people who have adjustable rate mortgages have been refinancing into longer-term fixed-rate mortgages to avoid rising rates, especially since long-term rates have remained historically low for quite some time.

The speculation is that the Fed will raise the fed funds rate to 5.0%. However, no one is sure when the Fed will stop raising rates because it's almost impossible to accurately predict the future of something as complex as the U.S. economy. Either way, it is important to understand some of these market dynamics because a lack of understanding can sometimes cost you a lot of money.

Interest rates are influenced by supply and demand. When the economy is robust and borrowing is strong, interest rates rise. When the economy softens and there is less borrowing, interest rates go down. However, interest rates are also influenced by what the Federal Reserve, also known as “the Fed”, does and where the fed funds rate is set.

When interest rates are rising, a fixed-rate mortgage is usually an ideal choice, since it locks in the current rate and protects you from future rate hikes. When rates are falling, an adjustable-rate mortgage becomes more attractive, as its interest rate changes periodically, allowing you to benefit from lower rates.

Some people choose an ARM even when rates are rising because the initial interest rate on an ARM can be substantially lower - as much as two percentage points lower than that of a 30-year fixed-rate mortgage. This means you will pay less until mortgage rates have increased a full two percentage points. After that, you will pay more than a fixed rate.

There are also hybrids ARMs, which have a fixed rate for a certain time period, typically 3 - 10 years, and then become adjustable. For example, a 5/1 ARM has a fixed rate for five years, after which the interest rate adjusts annually. Hybrid ARMs can be the right choice if you are planning to move within a few years or if rates are likely to rise in the short-term but then flatten or fall. However, these long-term trends can be difficult to predict. A change in the interest rate trend can make it worthwhile to switch to a different type of mortgage. When rates are falling, you can save money by moving from a fixed-rate to an adjustable-rate mortgage, so you can benefit from the lower rates. If interest rates appear set for a sustained rise, switching from an ARM to a fixed-rate mortgage can lock in a lower rate and protect you from higher payments. You can even use cash-out refinancing to borrow enough to pay off credit card debt accruing at a higher interest rate. Just make sure that any closing costs related to refinancing do not offset its benefits.

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