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Lower Interest Rates - What Does It All Mean?

In order to answer this question, you must first understand the four major interest rates that are affected by the Fed:

DISCOUNT RATE
The interest rate that banks pay when they borrow money directly from the Fed. This rate has been largely symbolic in the past because few banks actually take the Fed up on their offer!

Banks prefer to obtain short time financing by:

Issuing "commercial paper" - These are short term IOU’s of typically one to ninety days that are sold on the open market to Wall Street investors. Interest rates on these short term loans are often better than the discount rate offered by the Fed.

Borrowing money from other financial institutions using the Fed Funds Rate as illustrated below. In most cases, this rate is also better than the discount rate offered by the Fed.

Nonetheless, many banks in today's "credit crunch" environment have actually taken advantage of this opportunity to borrow from the Fed.

FED FUNDS RATE
This is the interest rate that banks pay when they borrow money from each other here in the U.S. This rate is also determined by the Fed because banks in the U.S. are part of the Federal Reserve System. You see, the Fed's main role is to maintain "monetary stability" by keeping a close eye on the flow of money throughout the economy. One way they do this is by regulating the interest rates that banks charge each other for short term funds.

LIBOR RATE
The London Interbank Offered Rate (LIBOR) is the interest rate that banks pay when they borrow money from other banks anywhere in the world (primarily in the international wholesale money market based in London). There are various types of LIBOR rates including the 1 week LIBOR, 1 month LIBOR, 6 month LIBOR, and 1 year LIBOR; these are the rates banks would pay if they want to borrow funds for 1 week, 1 month, 6 months, etc. Although the LIBOR rates are determined by the financial markets at any given time, they are very closely related to the Fed in that LIBOR most often changes when the market anticipates that the Fed will change their Fed Funds Rate. LIBOR is the base rate that is used on most adjustable rate mortgages (ARMs) in the U.S. and large corporate/commercial loans. The reason LIBOR is used most often for U.S. adjustable rate mortgages is because LIBOR is really the most accurate measure of a bank's cost of borrowing funds since most banks do business internationally these days.

PRIME RATE
This is the Fed Funds Rate + 3%. This is the base rate that is used for most consumer loans such as credit cards and home equity lines of credit, as well as most small business loans. Like the LIBOR, the Prime Rate is also tied to the Fed Funds Rate.

In response to the economic slowdown that has occurred due to the current credit crunch, the Fed has lowered the discount rate and then lowered both the discount rate and Fed Funds rate. Does this mean that more rate cuts are on the way through 2008 or should we expect that the Fed will sit tight for a while?

This largely depends on whether inflation remains under control.

As the Fed lowers the Fed Funds Rate, the business and consumer based interest rates of LIBOR and Prime will also go down as illustrated above. The Fed would be reluctant to continue lowering rates if they feel that businesses and consumers would start borrowing and spending so much money that inflation will go up significantly.

Remember, the Fed's primary responsibility is to "maintain monetary stability" by keeping a close eye on the flow of funds in the U.S. economy. It would be reckless of them to artificially encourage too much borrowing and spending as this would serve to unrealistically drive up asset prices and cause money to lose its purchasing power as it did in the 70’s. This condition is known as the "I" word ... INFLATION. The good news is that inflation, at least for the time being remains in check.

HOW DOES THE FED AFFECT MORTGAGE RATES?
Well, if you have a home equity line of credit based on Prime or short term ARMs based on LIBOR, you should see a reduction after a drop in your interest rate. However, if you are considering a fixed rate loan or longer term ARM with a fixed period of 3, 5, 7 or 10 years, rates on those types of loans are not directly related to the Fed. Instead, these rates are closely tied to the Mortgage Backed Securities that trade on the bond market, which is a different story altogether.

As you can see, the decision to go with a fixed vs. adjustable rate mortgage can fluctuate with current conditions and your personal long-term goals. Always consult with qualified professionals before deciding upon which route to take!