There appears to be a lot of confusion about what the Federal Reserve did last week in response to the developing credit and liquidity crisis. The Fed lowered the “Discount Window” rate by .5%. The Discount Window rate is the interest rate that the Fed charges banks for short term loans, typically overnight. The Fed did not lower the Fed Funds rate which is the rate that Banks charge each other for overnight loans. Prime rate is tied to the Fed Funds rate and not the Discount Window rate. Currently the Fed Funds rate is 5.25% and prime rate is always the Fed Funds rate +3% or currently 8.25%. As most of you know Prime rate effects things like equity lines of credit, car loans, credit car interest rates etc. The Feds actions will not have an effect on Prime rate and will not have a direct effect on mortgage interest rates. Most analyst are predicting that the Fed will lower the Fed Funds rate later this year which in tern would mean that Prime rate will go down accordingly. The relationship between Prime Rate and mortgage interest rates is also generally misunderstood. In most instances when the Fed lowers the Fed Funds rate and thus prime rate mortgage interest rates will actually go up slightly. The reasons for this inverse relationship are varied and a topic for a future post.
Below is a chart of the history of Prime Rate since January 1994.
To keep things in perspective below is a graph of 30 year fixed rates on conventional mortgages since 1975. As you will note we are currently in a very favorable interest rate environment. The historical average for 30 year fixed rates 9.5% and with rates currently below 7% it is indeed a great time to buy real estate.
