PARAMOUNT MORTGAGE - LENDER'S BLOG

By David Goldman, CNNMoney.com staff writer

NEW YORK (CNNMoney.com) -- The Federal Reserve cut interest rates by three-quarters of a percentage point Tuesday, but don't expect mortgage rates to go down too. In fact, home loans could be heading higher.

Consider recent history: The Fed issued an emergency cut of short-term rates in early January, and then trimmed more just a few days later - but the 30-year fixed mortgage rate has responded by bouncing up from 5.6% to 6.4%.

The Fed's main tool is control over the short-term fed funds rate, which determines what banks charge each other for overnight loans. Long-term mortgage rates are mostly tied to the 10-year Treasury yield, which is determined by bond traders worldwide.

"There is a long disconnect between the fed funds rate and fixed mortgage rates," said Keith Gumbinger, vice president of mortgage and consumer loan information publisher HSH.com.

Inflation drives long-term fixed rates. When the Fed cuts short-term rates, the intent is to lower borrowing costs for corporations so that they'll invest and hire. But this economic growth can lead to inflation.

That in turn leads bond traders to demand higher rates on their long-term bonds - and that drives up mortgage rates too.

"Mortgage rates are determined by how fearful the market is of inflation," said Gumbinger.

The Fed began a series of cuts to its key interest rate last September, taking the rate to 2.25%, from 5.25%.

ARM borrowers may get help. There is more of a connection between Fed rate cuts and short-term and adjustable rate mortgages (ARMs). In fact, homeowners with ARM loans could see lower rates from further interest rate cuts.

Adjustable rate mortgages are pegged to a number of different indexes, including the one-year Treasury yield and the international Libor, or London Interbank Offered Rate, which tend to move with the Fed funds rate.

With Tuesday's rate cut, the cumulative effect of the Fed cuts could entirely offset what would have been a significant rate reset for many homeowners.

For instance, a borrower with an adjustable rate of 4.5% could have faced a rate reset up to 7.5% before the Fed started cutting rates in September. Before the rate cuts, that homeowner would have seen an increase of $370 in monthly payments on a $200,000 loan.

But after Tuesday that rate could reset only a little higher. And for some, the rate might not go up at all - and may actually drop - according to Greg McBride of Bankrate.com. "The Fed rate cuts far are more significant to [borrowers with ARMs] in terms of staving off delinquencies on loans," he said.