The Types of Interest Rates Set by the U.S. Federal Reserve and Their Relationship to Mortgage Rates

 

 

 

I.   Several Differences in U.S. Federal Reserve Interest Rates

 

The U.S. Federal Reserve (Fed) has several types of interest rates, each with different purposes and applications. Below are the main types and how they differ:

 

 

 

✅ 1. Federal Funds Rate

      • Definition: The interest rate at which banks lend reserves to each other overnight.

      • Set by: The Federal Open Market Committee (FOMC) of the Fed.

      • Purpose: Main tool of monetary policy to control inflation and promote employment.

      • Impact: Serves as the benchmark for all other interest rates.

 

 

 

✅ 2. Discount Rate

      • Definition: The interest rate the Fed charges banks when lending directly.

      • Purpose: Provides emergency liquidity support to financial institutions.

      • Comparison: Typically slightly higher than the federal funds rate.

 

 

 

✅ 3. Prime Rate

      • Definition: The rate commercial banks charge their most creditworthy customers.

      • Not directly set by the Fed: But closely follows the federal funds rate.

      • Use: Affects consumer loans, mortgages, and business lending.

 

 

 

✅ 4. IOER (Interest on Excess Reserves) / IORB

      • Definition: The interest rate the Fed pays banks on excess reserve balances held at the Fed.

      • Purpose: Helps manage liquidity and support the Fed’s target interest rate.

      • Note: Now referred to as IORB (Interest on Reserve Balances).

 

 

 

🧠 Summary of Differences
Type Set By Applies To Purpose Relation to Fed Funds Rate
Federal Funds Rate Fed (FOMC) Interbank lending Monetary policy Benchmark
Discount Rate Fed Banks borrowing from Fed Liquidity support Slightly higher
Prime Rate Private banks Creditworthy customers Loan benchmark +3% above
IORB Fed Bank reserves Liquidity management Matches target range

 

 

 

 

 

 

II.   What Interest Rates Are Mortgage Rates Related To?

 

Mortgage interest rates are indirectly influenced by several other key interest rates. The two most important ones are:

 

 

 

✅ 1. 10-Year U.S. Treasury Yield

  • Most closely related: Fixed-rate mortgages (especially the 30-year fixed) tend to move in line with the 10-year Treasury bond yield.

  • Why?: Even though the mortgage term is 30 years, the average homeowner keeps their mortgage for about 7–10 years. So, investors treat 10-year Treasuries as a comparable benchmark.

  • Relationship: When the 10-year Treasury yield rises → mortgage rates tend to rise.

 

 

 

✅ 2. Federal Funds Rate (Fed Rate)

  • Affects adjustable-rate mortgages (ARMs): The Fed’s interest rate directly influences short-term interest rates, including ARMs.

  • Indirect influence: The Fed rate also impacts overall borrowing costs across the economy, which can shift mortgage rates over time.

 

 

 

🧠 Other Related Factors
Factor Impact
MBS Yields (Mortgage-Backed Securities) As yields on mortgage bonds increase, lenders raise mortgage rates to maintain profit margins.
Borrower’s Credit Score (FICO) Higher credit scores usually qualify for lower interest rates.
Loan-to-Value Ratio (LTV) A larger down payment can lead to a lower interest rate.
Inflation Higher inflation generally leads to higher interest rates, including mortgage rates.

 

 

 

 

🔁 Summary Table
Mortgage Type Most Related Interest Rate
30-Year Fixed 10-Year Treasury Yield
15-Year Fixed 5–10-Year Treasury Yield
Adjustable-Rate (ARM) Federal Funds Rate
HELOC / Second Mortgage Prime Rate

 

 

 

 

 

 

 

III.   Explanation with Current Interest Rates Applied (as of June 2025)

 

Interest Rate Type Current Level Description
Federal Funds Rate 4.25% – 4.50% Target range for overnight interbank lending. Held steady at June 18, 2025 FOMC meeting.
Discount Rate 4.50% Rate the Fed charges banks for direct loans. Typically 0.25% above the Fed Funds Rate.
Prime Rate 7.50% Set by banks, usually 3% above Fed Funds Rate. Affects consumer and business loans.
IORB (formerly IOER) ≈4.25% – 4.50% Interest on reserve balances held at the Fed. Helps support Fed’s target range.

 

 

 

 

🧩 Key Observations

 

      1. Monetary Policy vs. Actual Lending

        • Fed Funds Rate: Governs overall rate policy.

        • Prime Rate: Influences mortgage, credit card, and business loan rates.

      2. Liquidity Tools

        • Discount Rate: Used in emergencies when banks need direct funds from the Fed.

        • IORB: Encourages or discourages banks from holding reserves.

      3. Rate Relationships

        • Discount Rate is usually 0.25% above Fed Funds Rate.

        • Prime Rate is typically 3% above Fed Funds Rate.

 

 

 

 

🔍 Economic Outlook (as of June 2025)

 

      • The Fed held interest rates steady at the June 18 meeting.

      • Fed officials indicated the possibility of two rate cuts later in 2025.

      • The market anticipates the first cut potentially in September.

 

 

 

✅ Summary

      • Federal Funds Rate: 4.25–4.50% – The benchmark rate for short-term lending between banks.

      • Discount Rate: 4.50% – The interest rate at which the Federal Reserve lends directly to banks.

      • Prime Rate: 7.50% – The base rate banks use for lending to their most creditworthy customers.

      • IOER: ≈4.25–4.50% – The interest paid by the Fed on excess reserves held by banks.

 

 

 

Thanks to this system, the Federal Reserve is able to manage short-term market rates around the benchmark rate and influence the overall economy.  Since a rate cut is expected later this year, it’s advisable to take that into consideration when planning loans or investments.

 

 

 

 

 

 

 

Terry Kwon

Contact: (631) 624-4480

Email: terry@milestonepointinc.com

 

Funding Director at Milestone Point, Inc.

Licensed Mortgage Originator at Loan Factory

NMLS #2620208

Loan Factory NMLS #320841