What does the Fed Discount Rate mean to you? : Rooftop Views

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What does the Fed Discount Rate mean to you?

The Federal Reserve has taken significant action in the last few weeks due to the credit crunch. And now they've made an unexpected move by cutting the discount window rate, which is great news. We'll get to that in a minute, but first let's look at recent events and understand what they mean.

Market movement

To date, over 120 mortgage companies have closed their doors due to reduced liquidity. The result: borrowers who want to take out non-conforming loans have fewer, more expensive options. Many media outlets have incorrectly added fuel to the fire by stating mortgage lending has stopped altogether and borrowers can't get a loan without a 20% down-payment. This is not true.

Conforming interest rates and loan programs, those backed by Fannie Mae and Freddie Mac, have not been significantly impacted by recent events. Even better, interest rates have come down from recent highs. While this is good news, the market is experiencing unprecedented volatility and changes could come at any time. Borrowers need to act swiftly and decisively in today's climate.

What did the Fed do?

Now back to the discount rate. This is the interest rate charged to commercial banks and other depository institutions on the loans they receive from their regional Federal Reserve Bank's lending facility. The Fed's decision to cut this rate provides stability in the financial markets and this can be good for all of us. How exactly does this provide stability? Here's an example: imagine you just wrecked your car and it requires $5,000 worth of repairs. You have a short-term need for cash to pay your mechanic. Even though you know you will eventually be reimbursed by your insurance company, you still need the cash now. So, do you sell off stocks to get the cash, or tap into an equity line of credit? Most likely, you draw from that line of credit rather than liquidating a long-term investment.

This is what the banks are facing in today's liquidity crisis. And Bernanke's move helps them avoid long-term damage by supplying access to short-term cash.

It's important to note the discount rate is different than the Fed Funds Rate, which directly impacts interest rates you pay for Home Equity Lines of Credit, credit cards, and automobile loans. Most importantly, the discount window rate cut does not directly impact home loan rates.