Star Tribune

MINNEAPOLIS – On Thursday the Federal Reserve Bank continued what it began two years ago: raising the cost of borrowing. While long-term fixed-rate mortgages including the 15- and 30-year mortgages – the industry standards – aren’t tied directly to the Fed’s rate increases, that’s not the case with short-term mortgages, which typically move in lock-step with the Fed fund rate.

During the past 24 months, for example, the cost of a one-year adjustable rate mortgage has climbed 38 percent, and that is having a trickle-down effect across the entire economy but most especially the once-hot real estate market. On Thursday the Fed Reserve Bank increased its federal funds rate a quarter percentage point to 5.25 percent, and more increases are expected.

“The housing market is the most interest-rate sensitive sector of our economy,” said Frank Nothaft, Freddie Mac’s vice president and chief economist. “With rates moving up, that’s leading to a moderate and orderly cooling in the housing sector.”

When the Fed made the first of its 17 rate increases in June of 2004, short-term mortgage interest rates were at record lows and the real estate market was red-hot.

Two years ago, “There were multiple bids and people were offering far above the asking price,” said mortgage lender Clifford Morse, branch manager for American Home Mortgage in Chaska, Minn.

Borrowers took full advantage of low rates and attractive terms by buying bigger houses, refinancing consumer debt into their mortgages and buying second and third houses.

But with each successive Fed rate increase the cost of short-term borrowing has risen significantly, while long-term fixed-rate mortgages have increased more moderately. As the gap between these short- and long-term mortgage rates has narrowed, the allure of adjustable-rate mortgages has worn off.

Five-year Treasury-indexed ARMS averaged 6.39 percent this week, according to Freddie Mac. A year ago the five-year ARM average 5.19 percent. At the same time, the 30-year fixed-rate mortgage averaged 6.78 percent for the week ending June 29, the highest level in four years, but still well below the 35-year average of 9.4 percent, according to the Primary Mortgage Market Survey. A year ago that same mortgage averaged 5.62 percent.

That means refinancing doesn’t make as much sense as it once did and borrowers are losing buying power. During the first quarter of 2006, total mortgage originations fell 24 percent nationally and the share of refinancings is expected to drop to 33 percent.

Homeowners haven’t stopped refinancing, but they’re no longer doing it to get a better rate. Most are doing it to escape their adjustable-rate mortgages, which have begun adjusting upwards from rock-bottom teaser rates that were too low to resist.

The first quarter of 2006 was the first time in 20 quarters that the new rate was higher than the old one for more than half of all refinancings, according to Freddie Mac.

A slow-down in refinancings will have ripple effects throughout the economy that will be felt by everyone from car dealers to colleges as homeowners come to grips with the realities of a more normal market and less home equity.

During 2005 homeowners converted $244 billion dollars in home equity into cash; that number is expected to fall to $170 billion during 2006. Already, the market has returned to more sustainable levels with pending home sales slowing and inventory rising to record levels. Nationwide, single-family construction, single-family home sales and single-family price appreciation all peaked during 2005.

“With higher interest rates, the house market has begun a gradual and orderly reversion towards historical norms,” Nothaft said.