Keeping an eye on interest rates

Mortgage lenders charge you an interest rate that is tied to an index rate. Some of the major interest rates used as indexes for mortgage loans — including loan refinancings — are:
Deciding when to refinance depends on the level of interest rates. Over years, interest rates rise and fall with the economic cycle. When the economy is expanding, demand for loans is high. High loan demand leads to higher interest rates. When the economy slows down or contracts, the demand for loans is low.
A slowdown in the economy leads to lower interest rates, making it a better time to refinance.
  • Treasury bonds. The yield on 10-year Treasury bonds is often used as an index for 30-year, fixed-rate mortgage loans. Yields on the 1-year Treasury bill are often used as an index rate for adjustable-rate mortgage loans.
  • Government agency bonds. Yields on agency bonds are sometimes used as index rates for mortgage loans. Agency bonds include securities sold by Fannie Mae, Freddie Mac and Ginnie Mae. These are quasi-governmental organizations that buy mortgage loans from lenders, repackage them as securities and sell them to investors. This market for buying and selling these mortgage-backed securities is called the secondary market. By creating a secondary market, lenders can free up some of their capital to make new mortgage loans.
  • Cost of Funds Index (11th District). The Eleventh District of the Federal Home Loan Bank Board (FHLB), which covers California, Nevada and Arizona, publishes a Cost of Funds Index. The COFI index is frequently used as an index on adjustable-rate (ARM) loans. Other regional offices of the FHLB have their own indexes, but the Eleventh District’s index is the most widely used.
  • LIBOR. Other interest rates are increasingly used as indexes for ARM loans. Occasionally, the London Interbank Offered Rate (LIBOR) is used as an index rate for some mortgage loans.
The Federal Reserve’s monetary policy influences the direction of interest rates, which directly affect mortgage interest rates. The Fed’s main policy-making arm meets about every two months to evaluate the nation’s economic health. If the Fed thinks a slowdown is on its way or continuing to weigh down the economy, it may decide to cut the fed funds rate, a short-term interest rate. On the other hand, the Fed has a reputation for fighting inflation by hiking the fed funds rate.
As it actually happened, the Fed cut the fed funds rate 11 times in 2001 to stave off a slowing U.S. economy that finally fell into recession in the first quarter of the year. Similarly, the Fed has raised the fed funds rate 17 times between June 2004 and June 2007 to ward off inflation. Since then, the Fed has steadily lowered interest rates to the point where the federal funds rate is just above zero.

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