Question: My husband and I are planning to purchase our first home by the end of the year. I would like to start house hunting right away, but my husband thinks it's best to borrow when the Federal Reserve lowers interest rates. Do you think we should wait until interest rates drop again before we buy a house?

Answer: There is an enormous public misunderstanding regarding the relationship between the Federal Reserve's interest cuts and mortgage rates.

Every time the Fed lowers interest rates -- seven times so far this year -- my office gets swamped with calls from folks who assume that mortgage rates will suddenly drop. In reality, every time the Fed has lowered short term rates this year, mortgage rates have actually increased.

Let's go over this in some detail.

The Federal Reserve controls short-term interest rates. Specifically, it has the ability to move the federal funds rate, which is the rate that financial institutions such as banks charge each other for overnight funds. Technically, the federal funds rate has nothing to do with mortgage rates.

Mortgage rates are governed by market forces and are similar to Treasury bonds. Watching the movement of the 10-year Treasury bond is a great way to get an idea of where mortgage rates are heading.

If we look at this logically, a drop in short term rates by the Fed should help reduce mortgage rates. When Federal Reserve Chairman Alan Greenspan decides to cut rates, he is trying to stimulate the economy by making short-term borrowing less expensive. This effect should eventually spread to long-term rates such as mortgages.

Why hasn't this happened this year?

Instead of the short-term rate drop trickling over into the mortgage market, investors interpreted rate cuts as beneficial to the stock market. They then pulled money out of the safe bond market and put it back in stocks. Generally -- but not yesterday when the Fed announced its seventh rate cut in 2001 -- when the Fed has lowered rates this year the stock market enjoyed immediate gains. Unfortunately for stock investors, these gains have been short lived -- and yesterday there were few gains to be had.

Here's the bottom line: The Fed's decision to cut short-term interest rates does not in any way mean mortgage rates will immediately drop. So to answer the question: Don't try to time the market. Instead, begin your house search, get pre-approved, and you'll be ready to strike when you find the home you love.

Published: August 22, 2001

Use of this article without permission is a violation of federal copyright laws.

, the president of PMC Mortgage Corporation in Alexandria, VA, is a mortgage columnist whose work has appeared in numerous consumer, real estate, and mortgage publications. Mr. Savage welcomes your questions for possible use in this column, however because of the volume of mail received, Mr. Savage cannot answer questions individually.