On Tuesday the Federal Open Market Committee (FOMC) dropped the federal funds rate by 0.75% in an emergency meeting. What does this mean for mortgages? The federal funds rate does not actually directly impact fixed mortgages. Because fixed-rate mortgages are long term loans, they tend to more closely follow long-term paper such as the 10-year treasury note and 30-year treasury bond. The 10-year treasury note and 30-year treasury bond have been on a steady decline since July, as have 30-year and 15-year fixed mortgage rates.
Treasury yields have dropped quite a bit in the past two days since the FOMC announcement which is good news for anyone looking to buy a home. The yields aren’t dropping so much as a direct result of the federal funds rate drop, but more because of the message the FOMC has sent as a result of the action they have taken. I read a good article this morning that describes the situation well:
Mortgage rates often dip when investors fearing an economic slowdown grow more conservative and buy up Treasuries and bonds. This causes long-term rates — and by extension, mortgage rates — to fall, creating an opportunity to get better terms on a loan.
Although normally this would be good news for borrowers with adjustable rate mortgages that wish to lock into long-term fixed-rate mortgages, they may still find themselves unable to refinance. During the housing boom many people used adjustable rate mortgages with small down payments to purchase their homes. They did this in anticipation that home prices would continue to climb, and the market value would allow them to build equity in the home. Unfortunately when the real estate market topped out, these individuals were left with very little home equity or even worse, negative equity in their homes.
With little or no equity in a home, it will be very difficult to refinance into a fixed-rate mortgage. Without at least 20% equity in a home, a homeowner will have to pay Private Mortgage Insurance (PMI). This helps lenders to recover losses from defaults and provides no benefit to the borrower. I have no doubt that PMI premiums have increased ever since the subprime lending issues began. This means a higher monthly payment which may not make it worth refinancing since it could possibly push a homeowner into negative cash flow. On top of having higher payments with PMI, payments on a fixed-rate mortgage will include principal as well as interest. Once again, the higher payment could force a negative cash flow situation. Even given all that, with lenders tightening borrower requirements, it may only be possible for those with excellent credit to refinance if they have very little or no home equity.
So what is a homeowner with an adjustable rate mortgage and very little equity to do? Well, one good thing about the reduction in the federal funds rate is that it could possibly lower the monthly interest payments. This would allow a homeowner with an adjustable rate to increase the amount of principal paid, hence build some equity. Hopefully the decrease in short-term rates will help homeowners with adjustable rates to build sufficient equity and allow them to refinance before fixed-rate mortgage rates begin to increase once more.