Generally speaking, interest rates are influenced by supply and demand. When the economy is robust and borrowing is strong, interest rates rise. When the economy softens and there is less borrowing, interest rates go down.
But interest rates are also influenced by what the Federal Reserve, also known as “the Fed”, does and where the fed funds rate is set.
Short-Term & Long-Term Rates
The federal funds rate, also known as the “fed funds” rate, is the interest rate charged when banks lend funds to one another. This is a short-term rate, or a rate that is two years or less in maturity. When Bernanke raises or lowers the fed funds rate, it affects mortgage rates that are tied to short-term interest rates, such as home equity rates and adjustable rates. When short-term rates fall, borrowing and spending usually increase. This can cause inflation, something the Federal Reserve wants to keep in control.
Long-term interest rates, or rates that are 10 years or more in maturity such as for 30-year mortgages, are influenced by short-term rates in a round-about way because they can rise when concerns about inflation increase. To keep inflation under control, the Fed started raising short-term interest rates in 2004. Because of this, people who have adjustable rate mortgages have been refinancing into longer-term fixed-rate mortgages to avoid rising rates, especially since long-term rates have remained historically low for quite some time.
The speculation is that the Fed will raise the fed funds rate to 5.0%. However, no one is really sure when the Fed will stop raising rates because it's almost impossible to accurately predict the future of something as complex as the U.S. economy. Either way, it is important to understand some of these market dynamics because a lack of understanding can sometimes cost you a lot of money.
