This article explains the interest rate regimes crucial to California real estate transactions and how the Federal Reserve influences interest rates.

The heady discount rate at work

Commercial banks are the delivery network for moving U.S. dollars to individuals and businesses necessary to buy things efficiently. To distribute money, banks borrow money, expectantly called savings deposits, which they lend to members of the public.

Minimum cash reserve requirements are wisely imposed on banks to prevent a liquidity crisis from arising out of lending to the pubic or repayment of deposits. Critically, to ensure banks have an adequate supply of money to lend to the public and to repay depositors, the Federal Reserve (the Fed) makes loans to banks as a function of its roles as the lender of last resort — and ultimate stabilizer of economic activity.

When lending money to commercial banks, the Fed charges banks a variable rate of interest called the Fed discount rate.

Recessions, private lending and the loan brokerage cycle together

In application to California real estate mortgage lending, the Fed discount rate limits interest earnings on “no-broker” mortgage originations by private money lenders funding a borrower’s business-use purpose — investment, business or agricultural.

However, during recessions, cash fast becomes king.

Conventional (institutionalized) lenders fade, reducing lending, the product of MLOs. Private lenders —  individuals with cash savings — quickly realize trust deed investments are generating double digit interest rate earnings, and that ownership of real estate is becoming problematic. They are reciprocals in a business cycle.

But before private lenders can get in on the double-digit annual earnings, they need to employ a loan broker – or on the oft chance are one themselves.

For private money lenders who fund mortgages, the discount rate is a component of the interest rate ceiling imposed by California usury laws, unless the mortgage is exempt as a “brokered loan.” A private money mortgage made or arranged by a Department of Real Estate (DRE)-licensed broker is exempt from the usury law annual earnings ceiling. Unconscionable rates become the “usury” rate limits.

For private money mortgage lenders, the Fed’s discount rate applies via our usury law when:

  • the private lender is not a licensed real estate broker; or
  • a real estate broker does not arrange the origination of the mortgage.

The discount rate component for usury limits is set each month. The discount rate for a specific month applies to private money mortgages agreed to during the month — not based on the month the mortgage is funded or originated.

While the discount rate itself may vary from month to month, the discount rate used for a mortgage is fixed for the life of the mortgage.

The maximum annual interest rate on non-exempt mortgages is the greater of:

  • 10% per annum; or
  • the discount rate plus 5%.

Thus, when the discount rate is below 5%, the maximum annual interest rate on non-exempt mortgages is 10%. However, as the discount rate continues to creep higher in 2023, the ceiling will soon rise to above 10%.

Federal funds, the rate charged, and why

The welfare of owners strapped with an adjustable rate mortgage (ARM) encumbrance — and thus their standard of living — is improved or worsened by a move in the Federal fund rate.

For the past three decades, the Federal fund rate has trended consistently downward, into 2012. During those three decades, the ARM generally increased property owners’ disposable income by reducing payment amounts on their ARM.

All that has reversed. Disposable income is now being reduced as monthly payments on the owner’s ARM increase.

Federal funds are overnight funds lent to a bank in need of reserves by other banks with excess reserves, or by the Fed. Depending upon current rates charged by the Fed, banks prefer to borrow from one another rather than the Fed.

The Fed uses the discount rate and the Federal funds rate to control short-term interest rates.  When the Fed tightens monetary policy, say, to reduce the rate of consumer inflation, it will sell government securities it holds. This sell off withdraws cash funds held by banks and thus reduces bank reserves. In turn, this reduces lending to the public. Likewise, to induce banks to buy securities from the Fed, the Fed increases their Federal funds rate.

However, any increase in the Federal funds rate directly causes rates to increase in other short-term money instruments such as Treasury bills, certificates of deposits (CDs) and repurchase agreements (RPs). In the real estate market, movement in the federal funds rate brings on movements in ARM indices. In turn, this triggers adjustments in the note rate and payment schedules for existing ARMs.

Fixed rate mortgages (FRMs) are not directly affected by the Federal funds rate. Instead, FRM rates are tied to 10-year Treasury notes, controlled by the bond market.

A Fed decision to increase short-term rates is spurred by the Fed’s perception that higher consumer price inflation looms in the future due to a developing excessive demand for goods and services and a tightening labor market.

Or, as during 2022, the Fed increases its Federal funds rate to counter inflation which began running dangerously hot due to abundant fiscal and monetary stimulus during the pandemic period.

The Fed tightens credit by increasing short-term rates. This directly raises the cost of borrowing for businesses, governments and buyers of all sorts of big-ticket items such as cars and appliances on credit. On tightening, the availability of money is limited, slowing all types of purchases (spending). This axiomatically slows the economy down, decreasing the level of price inflation and slowing (or stopping) job and wage growth.

One of several indices mortgage lenders use in their ARM note to periodically adjust their interest rate charge is the Treasury Securities (TS) average yield index. This index is an average of T-Bill yields with maturities adjusted to one year. The interest rate on an ARM tied to the TS index equals the T-Bill yield plus the lender’s profit margin, a formula set out in the note.

Thus, all interest rates work like a tax on income to take money out of or put money in the hands of consumers, especially owners of property encumbered by ARMs.

Prime rate

Business loans are short-term loans originated by banks at interest rate charges tied to the prime rate, also called prime-based loans.

For real estate loans, application of the prime rate is limited to junior financing, second trust deed loans such as home equity line of credit (HELOC) credit lines and piggyback second trust deeds originated with an 80% LTC first mortgage. As prime rate mortgages, the interest rate charged and payment amounts will vary over the life of the loan.

The prime offer rate index is one of several referenced by lenders in their ARM notes to set the base rate, to which they add a margin of 2% or 3% to set the interest charges. They quote these ARMs as prime-plus mortgages.

The prime rate is set in unison by U.S. banks at 3% over the Federal funds rate. The prime rate adjusts in tandem with each Federal fund rate change.

Borrowers with high credit scores may have their interest set at a lower rate, such as the Secured Overnight Financing Rate (SOFR), which replaced the less reliable (and easily corruptible) London Inter-Bank Offered Rate (LIBOR) in 2022.

A line chart of the cost of borrowing cash overnight collateralized by Treasury securities

Tea leaves: CPI, Fed monetary policy, 10-year T-note and FRMs

The Fed infrequently takes direct control over long-term interest rates, such as the 15- and 30-year FRM rates.

The Fed did so during the periods of 2009 to 2012 following the 2008 recession, and again in the 2020-2021 pandemic economy. Both times, the Fed pumped money into FRMs due to the lack of mortgage funding in the bond market. Thus, the Fed steps in as the lender of last resort when the bond market fails to support mortgage backed bonds (MBBs), which fund FRMs.

However, one of the Fed’s primary designated tasks is to control the level of consumer inflation. The Fed exercises control by moving the short-term rates up or down. It is the degree of the Fed’s success managing inflation that influences expectations of bond market investors about future inflation rates.

Soon, the bond market’s perception about the rate of inflation they can expect in the future is reflected in long-term interest rates they demand on 10-year Treasury bonds.

For example, throughout 2022 the Fed increased short-term interest rates by leaps and bounds. The Fed did this to fight inflationary pressures which had developed in the economy due to high demand for goods and services fueled by an excess of pandemic-era stimulus and supply chain disruptions.

Sensing the Fed was unwilling to take sufficient action to quickly knock down the distorted level of inflation that developed in 2021, bond market investors began to demand higher rates. They anticipated a prolonged period of risk due to lingering higher inflation. Thus, long-term interest rates began to rise rapidly in 2022 which included rate hikes on MBBs, the source of FRM funds.

To compound the costs of cash, mortgage lenders originating FRMs began demanding a higher risk premium, almost double the historic rate.  The increase accounts for their anxiety over the coming rise in mortgage defaults.

The result: significantly higher mortgage interest rates in 2022, which slashed buyer purchasing power — and, in turn, home prices. In short: not a good time to be a seller.

Related article:

California tiered home pricing

Applicable federal rates (AFRs) & carrybacks

As mortgage money from conventional sources dries up, and private money mortgages exact too high a cost and due date risks, sellers will become the source of credit. They will simply offer to carry the mortgage — a carryback note and trust deed — in an installment sale on a grant deed conveyance to a buyer.

With a carryback, the seller is able to get “their asking price” by carrying paper — after a respectable down payment — at a very low interest rate, but better than a savings account rate. This, of course, keeps the profit high. However, at tax time, the Internal Revenue Service (IRS) has a device to neutralize this effect — the AFR.

Applicable federal rates (AFRs) set the minimum interest yield reportable as income by a seller on financing they carried back on the sale of any type of real estate. The AFR the seller reports when the carryback note rate is less than the AFR is called imputed interest.

It is the seller’s duty as a taxpayer to calculate — impute — what portion of principal is annually allocated to interest income, then report and pay taxes on that amount as interest income. The buyer is not involved with AFR treatment as the buyer reports interest deductions at the agreed carryback note rate.

The AFR is unique to each carryback note and is selected based on:

  • the date on the purchase agreement that created the carryback debt, to locate the AFRs for that date;
  • the due date in the carryback note which falls within one of three categories:
    • short-term — three years or less;
    • mid-term — more than three years through nine years; or
    • long-term — more than nine years; and
  • the periodic payment scheduled on the note, whether monthly, quarterly, semi-annual or annual payments.

Twelve AFRs are set monthly by the IRS, one rate for each possible selection.

The listed rates are for monthly payments.

A bar chart measuring rates for federal income tax

The result of imputing interest on a carryback note when the note rate is lower than the AFR is a reallocation of principal to interest income. Thus, for tax reporting when a profit is taken on a carryback sale, the imputed amount is shifted from profit tax rates to ordinary income tax rates. The drama in taxation.

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