ARM vs Fixed Rate Mortgages: Fed Discount and Funds Rate Connection

Fed cuts only the discount rates, not all interest rates in general. Discount rate is the rate that the Federal Reserve banks charge financial institutions for overnight loans. This and the closely related funds rate are the only interest rates that the Fed administers and as such has absolute power over only those rates. Those rates are very short-term, making the Fed’s influence confined only to short term lending rates. The misconception however is the impression that the Fed is in some way paving way for cutting all interest rates including mortgage rates. A vague connection between discount rates and mortgage interest rates does exist but whether refinance decisions can be based on it is debatable.

Longer-term bond interest rates such as the 10-year constant maturity Treasury bond rate and the trend of the stock market are both good pointers for a correlation to the mortgage interest rates. The reasoning being
  • Stock market going down implies there is less demand for stocks and the investor’s money goes more towards the bond market. The bond prices go up and the interest rate on them goes down. A refinance decision based on such a parallel can be made if one is able to predict the direction of the rate or the future direction of stock prices.
Accurately predicting the direction of any market-driven interest rates and stock prices are exercises in futility and so those approaches are faulty, although the media projects them as being very valid. An approach is to make the refinance decision by pitting closing costs for the new loan against the monthly savings realized by refinancing. It pays to consider the length of the new amortization schedule against the existing schedule.

Refinancing to an adjustable rate mortgage (ARM) based on the correlation between short-term interest rates and the Fed discount rate is another option. Such a mortgage could be used as a stepping-stone to a fixed rate mortgage refinance at an opportune time in the future. The strategy lets you take advantage of the slow moving nature of some of the indexes the ARM’s are based on. The obvious advantage is its potential to buy time. Specifically, refinancing when the ARM rates are very low enables one to track the fixed rate mortgage indexes and to make a balanced decision in refinancing to a fixed mortgage over an extended period of time as opposed to having to commit to the available rate at the time of purchase of the property. The wide array of choices in the ARM market allows one to take as much or as little risk as one prefers. For example, a one-year MTA index based ARM with mortgage adjustments every six months after the first year capped at 2% have a lower interest rate but is riskier than a 7-year ARM with mortgage adjustments every year since then with a cap of 1%.

One potential downside to using refinancing is the possible loss of certain borrower rights under the anti-deficiency statute.

Last Updated: 01/2015.

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