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How rate cut may affect you

August 18, 2007|Kathy M. Kristof | Times Staff Writer

When the Federal Reserve cut its so-called discount rate Friday in an effort to ease a growing credit crunch, the central bank turned to a mechanism that isn't a topic of everyday discussion.

But you may be interested because the move might make it easier to get certain mortgages. And the Fed's action could foreshadow a reduction in a more noteworthy interest rate next month.

Here are answers to questions about two key Fed rates and their effect on consumers:

What is the discount rate?

It is the rate banks pay when they borrow funds directly from the Federal Reserve. A change in the discount rate has no direct effect on interest rates consumers pay on mortgages, credit cards and other debt, but lowering the rate makes money more available to banks and, by extension, theoretically, to consumers. The Fed cut this rate Friday by half a percentage point -- a significant reduction in the world of interest rates -- and loosened other terms that would apply to such loans the Fed makes to banks.

Why would I care about that?

Because it might make it easier to get a home mortgage in California. Understanding why requires a little background.

Lenders that make "jumbo" mortgages -- loans larger than $417,000 -- generally sell them to investors. That gives the lenders more money to make more loans. But credit concerns in recent weeks have scared investors away from that "secondary" market. As a result, lenders have less cash, making jumbo loans harder to get and more costly.

The Fed's move gives lenders that can't finance these loans on their own the ability to borrow from the government to complete the mortgages in their pipeline. It also gives investors time to reconsider whether they might want to buy such loans.

In Los Angeles, where most mortgages are of the jumbo variety, that could mean the difference between buying a home and being shut out by financing constraints.

Will interest rates on jumbo loans come down?

In theory they should, said Peter Morici, professor at the University of Maryland School of Business and former chief economist at the U.S. International Trade Commission. If you increase the supply of money, assuming the demand for it stays constant, rates should decline.

How much could jumbo loan rates drop?

That's the $64,000 question, said Greg McBride, financial analyst with interest-rate tracker Right now, there's a bigger-than-usual gap between the cost of a "conforming" loan -- those for $417,000 or less -- and a jumbo. For example, the average interest rate offered on 30-year fixed-rate mortgages is 7.43% for jumbo loans and 6.68% for smaller mortgages. That extra interest would add $252 to the monthly payment on a $500,000 mortgage.

"Today's move may be the first step to a return to normalcy for jumbo mortgage borrowers," McBride said. But until the secondary mortgage market stabilizes, jumbo rates are likely to move down slowly, if at all.

Will the Fed's action affect interest rates on other debt?

No, but the Fed signaled that it would consider cutting its key short-term interest rate, known as the federal funds rate, when it meets Sept. 18. Some analysts say the Fed could do so even sooner. That could affect interest rates on a wide variety of loans.

What is the federal funds rate?

It's the rate at which banks make overnight loans to each other.

How would a lower federal funds rate affect me?

A cut in the federal funds rate would probably lead banks to cut their so-called prime rates. That in turn would lead to lower rates on many home equity lines of credit, personal loans and variable-rate credit cards. Auto loans also could be affected, though not as directly.

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