Deconstructing mortgage rates

We often talk about what you can do to make sure you’re prepared to apply for a mortgage and receive the best terms possible for your financial situation. Although several factors — like your credit score and debt-to-income ratio — are somewhat within your control, there are other circumstances that affect the mortgage rate you’ll pay.

Since you’re probably busy with your new home construction, we’ve put together an article you can quickly read about how mortgage rates are determined.

You may have seen headlines about the “Fed raising rates” and wondered how that affects you, a typical consumer — especially if you’ve been considering buying a home or tapping into its equity. According to the Board of Governors of the Federal Reserve System, the Federal Reserve performs five key functions including:

  1. Conducting the nation’s monetary policy.
  2. Helping maintain the stability of the financial system.
  3. Supervising and regulating financial institutions.
  4. Fostering payment and settlement safety efficiency.
  5. Promoting consumer protection and community development.

For the purpose of interest rates, we’ll focus on the first function — conducting the nation’s monetary policy. This responsibility is comprised of the Federal Reserve’s actions, as a central bank, to achieve the “dual mandate” goals specified by Congress: maximum employment and stable prices in the United States.

The Federal Reserve conducts monetary policy by using a variety of tools to manage financial conditions that encourage progress toward its dual mandate objectives. Monetary policy most directly affects the current and expected future path of short-term interest rates.

The federal funds rate is set by the Federal Open Market Committee (FOMC) and determines how much banks should charge each other for short-term lending, but also is tied to a variety of adjustable-rate consumer debt.

The FOMC is the policymaking body of the Federal Reserve System. It meets eight times each year to set the target federal funds rate, which is part of its monetary policy.

We currently have historically low unemployment rates, which is a good thing. However, this “good” news means that the Federal Reserve isn’t likely to lower its rates and is comfortable with rate increases. When unemployment is high, the Federal Reserve tends to reduce interest rates to stimulate borrowing, which can lead to workforce growth.

By raising its federal funds rate, the Fed is making it more expensive to borrow money, which is intended to reduce inflation. The cost of goods in the U.S. is up 8.5% year-over-year, according to the Labor Bureau’s most recent consumer price index data.

Typically, the central bank’s yearly inflation target rate is about 2%, because it stimulates the economy by pushing people to buy now rather than wait, especially if they think prices might rise in the future.

Since today’s inflation levels have reached the highest level in 40 years, interest rates are expected to continue going up throughout 2022. The Fed hiked the interest rate by 0.5% in May of 2022 and by 0.25% in March of 2022.

When the Federal Reserve makes it more expensive for banks to borrow by targeting a higher federal funds rate, lenders must pass the higher costs on to their customers — which leads to higher interest rates for mortgages, credit cards, car loans, and other consumer debt.

Although there is a relationship between Federal Reserve rate hikes and consumer loan interest rates, it’s not a direct correlation. In other words, the recent 0.5% Federal Reserve increase doesn’t translate to a mortgage interest rate that is exactly 0.5% higher.

There are far more complexities that contribute to consumer interest rates than we can cover in one brief article, but we hope this overview has provided you with an introduction.

Please reach out with any questions you have about getting a mortgage or how we can help with your construction process.

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