If you’ve picked up a newspaper or caught the news recently, you’ve probably encountered a story about mortgage rates and the Federal Reserve banking system. Like many borrowers, you might wonder how the Fed determines interest rates and how – in the event of a rate hike – your personal finances could be affected. Here’s a quick overview:

Banks, credit unions, and other lending institutions borrow money from Fed banks. Since they borrow these funds on a short-term basis, the institutions are charged at a discount rate that is set by the Federal Reserve Board. This discount rate has a direct effect on the “Prime Interest Rate,” the rate banks charge their top-rated commercial customers for short-term loans.

The Fed’s board of directors meets each month to set financial policy, adjust interest rates, and provide an economic forecast for the future. Since June 2006, the Fed has raised interest rates several times, a move designed to stabilize the economy that could translate to tighter cash-flow in your household. If you are juggling a mortgage, a home equity loan, and any amount of credit card debt or personal loans, this is probably a good time to assess the potential damage and, if necessary, refinance your existing mortgage.

Fixed-rate Mortgages

True, a 30-year fixed-rate mortgage may not be the most revolutionary option, but, in many cases, it is the smartest one. While the introductory rate on an adjustable-rate mortgage will probably be lower, payments on a fixed-rate mortgage won’t fluctuate, even if the Fed decides to increase the discount rate. For borrowers who want stability and are not planning to move within 5 – 7 years, the fixed-rate mortgage makes sense.

Adjustable-rate Mortgages

The chief advantage of an adjustable-rate mortgage or ARM is that the initial interest rate may be lower than that of a fixed-rate mortgage. However, the fact that your rate is adjustable means that you will likely see higher rates and bigger monthly payments, somewhere down the road. Some ARMs adjust on a monthly basis, but most adjust every 6 – 12 months, using a financial formula based on economic factors like federal interest rates.

Hybrid ARM

Many borrowers opt for the hybrid ARM, a mortgage that typically carries a low fixed rate for a set period of time (common hybrids are 1/1, 5/1, and 7/1), and thereafter has an adjustment interval of one year. Those annual adjustments are tied to federal rates. If you planning to live in your home for just a few years, the low introductory rates on a hybrid ARM might be a good bet, but beware the rate fluctuations to come.