Image courtesy of Getty Images, Illustration by Hunter Newton/Bankrate
The Federal Reserve does not directly set mortgage rates, but its decisions influence interest rate trends. At its most recent meeting on June 12, the Fed announced a pause on interest rate hikes for the seventh consecutive time after raising interest rates 11 times between early 2022 and mid-2023.
” [Federal Open Markets Committee] “Until we have greater confidence that inflation is sustainably moving toward 2 percent, we do not believe it would be appropriate to lower our target range,” Fed Chairman Jerome Powell said Wednesday.
The Fed has signaled plans to cut rates in 2024, but has continued to postpone any actual cuts. “Just as planes are delayed by 15 minutes with no end in sight, the timing of when the Fed will start cutting rates is equally uncertain,” says Greg McBride, CFA, chief financial analyst at Bankrate. On Wednesday, the Fed reduced its pace of rate cuts this year from three to one, reflecting the fewer meetings remaining.
Of course, mortgage rates can fluctuate even if the Fed keeps its key interest rate unchanged. So how do the Fed's monetary policy moves affect mortgages? Here's how it works:
Federal Reserve Activities
The Federal Reserve sets the cost of borrowing for short-term loans by changing the federal funds rate, which determines how much interest banks pay each other when they borrow money from the reserves they have on deposit with the Federal Reserve overnight.
The Fed raised this key interest rate in 2022 and 2023 to quell inflation, but the hikes made it more expensive for Americans to borrow money and access credit.
Fixed-rate mortgages (the most common type of mortgage) don't reflect the federal funds rate, but rather track the 10-year Treasury yield (more on that below). The federal funds rate affects short-term loans like credit card interest rates and interest rates on new home equity loans and lines of credit.
The Fed also buys and sells bonds in the money markets, which helps support the flow of credit and tends to have an overall effect on mortgage rates.
Factors that affect mortgage interest rates
Fixed-rate mortgages are tied to the yield on the 10-year Treasury bond, so if Treasury yields rise or fall, the interest rate on your fixed-rate mortgage will follow.
However, fixed mortgage rates are not exactly the same as 10-year rates, and there is a difference between the two.
Typically, the spread between the 10-year Treasury yield and the 30-year fixed mortgage rate is 1.5 to 2 percentage points. For much of 2023, that gap has widened to 3 percentage points, driving up mortgage costs.
Mortgage interest rates fluctuate for a number of reasons, including:
Inflation: Generally, when inflation rises, fixed interest rates rise as well. Demand and supply: When mortgage lenders are over-traded, they raise interest rates to reduce demand. When there is less activity, they tend to lower interest rates to attract more customers. Secondary mortgage market, where investors buy mortgage-backed securities: Most lenders bundle the mortgages they underwrite and sell them to investors in the secondary market. When investor demand is high, mortgage rates are a little lower. If investors aren't buying, interest rates may rise to attract more investors.
How the Fed is Impacting Adjustable Rate Mortgages (ARMs)
Fixed-rate mortgages dominate the U.S. mortgage market, but some Americans prefer adjustable-rate mortgages, or ARMs, which have interest rates that reset annually or semi-annually. The Fed's move could have a more direct impact on these mortgages.
More specifically, ARM interest rates are often tied to the Secured Overnight Financing Rate (SOFR). Because the Fed's interest rate decisions are the benchmark for savings vehicles, an increase or decrease in the federal funds rate can cause the SOFR to rise or fall. ARM interest rates will similarly rise or fall when interest rates reset.
This means that if the federal funds rate increases, your ARM interest rate will also increase at the next adjustment.
Things to consider when taking out a mortgage
Regardless of current Federal Reserve policy, your best bet to keep your mortgage interest rates as low as possible is to maintain strong credit, keep your debt low, make as large a down payment as possible, and shop around for loan offers.
When comparing rates, look at the APR, not just the interest rate. Some lenders advertise low interest rates but offset them with higher fees. Understanding the APR will help you understand your true total cost, including these fees.
Key Points on the Federal Reserve's Impact on Mortgage Rates
While the Federal Reserve doesn't set fixed mortgage rates, its policy decisions are tied to overall economic conditions that affect borrowing costs. In addition to the Federal Reserve's actions, mortgage lenders also consider factors such as the 10-year Treasury yield, inflation, and investor appetite when setting fixed rates. And when the Federal Reserve changes its benchmark borrowing rate, it also affects the index that impacts ARM interest rates.