If you’re thinking about buying a home or refinancing your mortgage, it pays to know how mortgages are affected by the federal funds rate, particularly with an interest rate cut expected at the September meeting next week. First, the Federal Reserve or “the Fed,” is the central bank of the U.S. Its job is to manage the supply of money and the cost of credit so that the U.S. economy can prosper. It also sets the federal funds rate, which is the interest rate that banks charge each other for short-term loans, directly affecting what consumers pay when they borrow money.
The Fed also influences mortgage rates, but doesn't set them. Instead, mortgage rates are affected by things like inflation, job growth, a shrinking or growing economy and more. The Federal Reserve's monetary policy is also a factor.
The Federal Open Market Committee (FOMC) said at its July 2024 meeting that although inflation eased over the past year, it still remains somewhat elevated. In response, the Federal Reserve kept the federal funds rate unchanged in a range of 5.25% to 5.50%, a 23-year high. The central bank also left the door open to the possibility of at least one rate cut this year, which many economists expect to happen at next week's Federal Reserve policy-setting meeting, sooner than previously expected. Depending on the outcome, it could mean relief for overly-inflated mortgage rates.
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The Federal Reserve and mortgage rates
While you can’t predict when some unexpected event will shock the market, it’s easier to make an educated guess about future mortgage rates by looking at the Fed’s current monetary policy. In a perfect world, the Fed would like to maintain an inflation rate of around 2%. However, inflation has been much higher than that for some time.
Variable rate mortgages, such as home equity lines of credit HELOCs) and adjustable-rate mortgages (ARMs) typically see rates decline after a Fed interest rate cut. According to Freddie Mac, the average ARM rate in the first quarter of March 2024 fluctuated from 2.73% to 3.12%. The HELOC rate hovered right around 4.3% to 4.4%, mostly flat.
Key points to consider:
- The Federal Reserve sets the federal funds rate, which in turn influences other interest rates, such as mortgages
- Mortgage lenders consider many different factors when determining the interest rates they charge.
- Although mortgage rates have started to decline, it will be a slow process. It’s unlikely we’ll see average rates dip below 6% for some time.
What this means for homebuyers
If you have been considering buying a home but couldn’t swallow mortgage rates that rose to 8% this year, (a mortgage of under 3% was possible just a few years ago) a Fed rate cut may help you make a decision by helping to lower your mortgage payments over time.
The difference between an 8% mortgage and a 3% mortgage on the same 30-year $400,000 loan is nearly $1,000 a month. That said, you should manage your expectations. It’s doubtful we’ll see 3% mortgage rates that were available during the pandemic anytime soon.
In addition to simply lowering your monthly payments, lower rates might convince more homeowners to sell. However, it may also mean more competition for the same home. Plus, the increased demand and the lack of inventory could drive up home prices and possibly offset the benefits of lower rates.
The impact of a rate cut on fixed mortgage rates
Because the 10-year Treasury bond rate influences fixed-rate mortgage rates and not the federal funds rate, homeowners who currently have a fixed-rate mortgage won't see their interest rate change regardless of moves by the Fed. However, borrowers applying for a fixed rate loan can lock in the new rate for the life of their loan, unless they refinance.
The impact of a rate cut on adjustable rate mortgages
The Fed’s rate cuts are more closely related to adjustable rate mortgages and HELOCs. That’s because the rate on an adjustable rate mortgage adjusts about every six months, so if the Fed keeps cutting rates, your monthly payment could gradually go down. On the flip side, your monthly payment could gradually increase if interest rates also increase.
Factors that affect mortgage rates
Mortgage rates are affected by many different factors, such as supply and demand, inflation and the jobs market. Personal factors like your credit score, borrowed amount and employment also play a part.
Economic factors:
- Inflation. When inflation is high mortgage rates tend to be high, although that’s not always the case. But because inflation often leads to consumers buying less, lenders make up for the loss by setting higher interest rates.
- Supply and demand. When the demand for homes is low, lenders tend to lower interest rates to attract borrowers. Conversely, when demand is high, lenders raise interest rates because they only have so much capital to lend in the form of mortgages.
- Job data. When the jobs market remains favorable and inflation holds above the 2% target, the Fed doesn’t have as much incentive to cut rates
- Fed policy. Although the Fed does not set mortgage rates, when it adjusts the federal funds rate, it does affect mortgage rates and what banks need to charge consumers to remain profitable.
The Bottom Line
If the Fed cuts rates at the September meeting, as it is expected to do, mortgage rates may drop, too. However, how much rates will drop is unknown because other economic conditions also play a part in how mortgage rates respond to the federal funds rate. Even so, mortgage rates and the federal funds rate usually take the same path. What’s hard to predict is whether mortgage rates follow the Fed's actions or the other way around.
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