What Does the Fed Rate Cut Mean for Mortgage Rates?

This article includes links which we may receive compensation for if you click, at no cost to you.

Should you drop everything, rush to a bank, and refinance your home because the Fed dropped its key lending rate?

Maybe so. A lower interest rate could save you tens of thousands of dollars in finance charges as you pay off your home.

But it’s not always this simple. Let’s explore what the Federal Reserve’s interest rate cuts mean for your personal situation.

What a Fed Rate Cut Means to Current Homeowners

The Federal Reserve sets the monetary policy for the U.S. economy — which by extension, influences the global economy.

But the Fed does not set actual mortgage interest rates. Individual lenders can raise and lower rates as they see fit.

But a lower interest rate at the Fed means your mortgage lender can better afford to lower its mortgage lending rates.

This means now could be a great time to refinance your current mortgage.

How Much Can the Fed Rate Cut Save You?

Let’s look at a typical scenario to see the impact refinancing can have on a home.

We’ll say you owe $219,000 on your current loan, which has a fixed interest rate of 6 percent.

Let’s also say you have 20 more years on your original 30-year loan, and you qualify for a new, 20-year loan at 3.5 percent interest.

Current Loan New Loan
Interest Rate 6% 3.5%
Loan Term 30 years 20 years
Monthly Payment* $1,500 $1,270
Interest Charged Over Time $142,200 $85,800
Total Cost to Pay Off Loan On Time $361,260 $304,800

*Does not include taxes, homeowner’s associations, or property insurance.

You can see why a homeowner might get excited. You could build a lot more financial freedom with an extra $56,460 saved over the next 20 years because of a lower interest rate.

Check out our mortgage refinance calculator to see how much money you could save on your home loan.

What About Smaller Cuts in My Rate?

But what if your current interest rate is already pretty good? After all, the economy was pretty weak back in 2010, and rates were low. If your mortgage originated then, you might already have a nice interest rate.

We’ll use the same example as above, but this time I’ll change your current interest rate to 4.75.

Current Loan New Loan
Interest Rate 4.75% 3.5%
Loan Term 30 years 20 years
Monthly Payment* $1,300 $1,270
Interest Charged Over Time $95,300 $85,800
Total Cost to Pay Off Loan On Time $314,260 $304,800

*Does not include taxes, homeowner’s associations, or property insurance.

In this example, the new loan would save only about $9,600 in finance charges over the next 20 years. Still a decent amount of money saved, right?

But closing costs — which could cost $4,000 to $5,000 — would cut deeply into these savings. Then you might think about the hours it takes to submit the loan application, documentation, and credit details.

It still may be worthwhile for you to refinance, but it’s definitely not as clear cut as the first example.

Why Do Smaller Rate Cuts Save Less Money?

This answer isn’t as obvious as you might think. Of course, smaller interest rate cuts mean you won’t see drastic savings.

But there’s another factor at play. If you’re 10 years into a 30-year mortgage, as in the examples above, you’ve already paid a huge chunk of your loan’s finance charges.

Here’s why: Lenders front loan your interest. The first payment you make may shave only pennies off your loan’s balance. Almost all of that first payment went directly toward interest.

Over time, the ratio of interest to the principal balances out. The final dozen or so payments you make on the loan will be almost all principal.

So when you refinance a 30-year mortgage after already paying on it for 10 years, you’re getting out of the loan just when you’re about to start gaining traction paying it off.

None of this matters much if you’re trimming 2 or 3 percentage points off your loan. It’s most likely worthwhile to refinance. But if you already have a pretty good rate, you may want to stay put.

Should You Keep or Refinance an ARM?

The examples above assume you have a fixed rate mortgage. A fixed-rate is a type of mortgage that maintains the same interest rate, and the same loan payments, throughout the loan’s life.

An adjustable-rate mortgage (ARM) may already fluctuate with the current mortgage market, especially if you’ve had it a while.

Most ARMs start with a low introductory interest rate then begin to change each year with the market. A 5/1 ARM keeps its fixed rate for five years. After that, the loan’s interest rate will change annually, depending on market conditions.

If you have an ARM when the Fed cuts interest rates, it’s probably a good time to refinance to a fixed rate mortgage, locking in the unusually low rates.

Otherwise, when rates increase again, your mortgage payment will rise, too.

Other Ways to Refinance After Fed Cuts

So far, we’ve talked about only a straight refinance in response to a cut in the Federal Reserve’s key lending rate.

Other types of loans may help you unlock savings as you rearrange your financing in response to the Fed’s cut:

Cash-Out Refinancing

Cash-out refinancing lets you claim the equity you’ve already built up while getting a new loan at a lower rate.

Your new loan would be large enough to pay off your existing mortgage balance and leave you with some additional cash to spend on home repairs or anything else you need.

Ideally, you’d put this “cash out” back into your home in the form of renovations, updates, or upgrades. But there are no rules about how you spend this money. It’s yours.

12- or 15-year Term Loans

When you’re 5 or 10 years into a 30-year mortgage, you can refinance at a lower rate while also shortening the term of your borrowing.

You’ll see an increase in your monthly payment, but you could save a tremendous amount in interest.

Let’s go back to the $250,000 home loan we used above, which has a balance of $219,000:

Current Loan New Loan
Interest Rate 4.75% 3.5%
Loan Term 30 years 10 years
Monthly Payment* $1,300 $2,170
Interest Charged Over Time $95,300 $40,870
Total Cost to Pay Off Loan On Time $314,260 $259,900

*Does not include taxes, homeowner’s associations, or property insurance.

If you can afford an extra $800 to $900 a month for your house payment, you could save $54,360 in interest charges by getting a 10-year loan — at a lower interest rate, of course.

See my post about 15-year vs. 30-year mortgages to learn more about the value of choosing a shorter-term mortgage.

Cash Out Loan With a Shorter Term

The two loans above — a cash-out refinance and a refinanced loan with a shorter term — can easily be combined to amplify the effects of a lower interest rate environment.

You could refinance with a shorter term, at a lower rate, and get cash out for home improvements.

Home Equity Loans

Homeowners who are happy with their current mortgage loans, either because it has a low rate or it’s almost paid off, can still capitalize on lower interest rates through a home equity loan.

These loans, often called second mortgages, borrow against the existing equity in the home.

In our $250,000 home from above, with $219,000 remaining on the balance, the equity would be $31,000 plus any additional value accrued since the purchase date.

Let’s assume the home has increased in value from $15,000 to $265,000. This means the homeowner “owns” this additional $15,000 plus the $31,000 already paid down from the original principal.

Together this equals $46,000 in equity, which you could access through a second mortgage.

You’d continue paying the original mortgage payments, and you’d also begin making payments on the second loan.

HELOC

You could also access the equity in your home by setting up a Home Equity Line of Credit (HELOC).

These loans resemble a credit card but with much lower interest rates because the equity in your home backs them.

HELOCs have a pre-set max, but you can access the money as needed. If you need only $12,000 to renovate a bathroom, you can withdraw — and make payments on — only that amount.

What Fed Rates Mean If You’re Shopping for a Home

What does it mean if you’re shopping for a new home — or just thinking about buying a home — and the Fed cuts interest rates?

It means you’ve hit the timing jackpot. You could finance your entire home with a 20- or 30-year loan and pay historically low interest rates, lowering your payment and your total amount of interest paid.

Rate cuts could even help you get into a 15-year loan instead of a 30-year loan, saving even more in interest.

But the Fed’s benchmark interest rate doesn’t automatically lead to interest savings.

Other factors in your interest rate include:

  • Your Credit Score: You’ll need a 700+ credit score to unlock the very best interest rates. You’d need a 620 to qualify for most subsidized loans. A few loans may let you in the door with a 580 score.
  • Your Down Payment: Putting 20 percent down helps you secure a lower interest rate — and you can avoid paying private mortgage insurance (PMI), in which borrowers who put less than 20 percent down usually pay on behalf of their lender.
  • Your Loan Type: 15-year loans usually allow for a lower interest rate compared to a 30-year loan. Rates for FHA loans may vary compared to VA loans or USDA loans.
  • Your ZIP Code: Geography influences interest rates in small ways.

Interest Is the Price Tag for Borrowing

Interest is the cost you pay to borrow money. A lower rate means you’re paying a lower price tag.

Timing your borrowing with rate cuts at the Federal Reserve — combined with keeping your credit score in good shape — can help you save more money or invest even more in real estate, opening the doors to a more stable and independent financial life.

Leave a Reply

Your email address will not be published. Required fields are marked *

In This Article