Many people think the Federal Reserve completely controls mortgage rates, but that’s not exactly true. The Fed does influence rates, mainly through the Fed Funds rate, which is the overnight lending rate for banks. This affects the short end of the yield curve, but the bond market plays a crucial role in setting the rates for longer durations.
For instance, if money market funds are offering a 5% return and are easily accessible, investors will demand even higher rates for longer-dated Treasury bonds to make it worth their while to lock up their money longer. Ultimately, it’s the bond market that really decides if the Fed’s rate decisions make sense, which in turn affects mortgage rates, which tend to follow the trends in the 10-year Treasury yield rather than the Fed Funds rate.
At the beginning of 2022, the Fed started raising rates to combat inflation, which had soared to 9.1% by mid-year. After 11 rate hikes, mortgage rates also jumped significantly, at one point spiking from 3% to 8%. Here’s a breakdown of that increase:
– 2.5% of the rise was due to changes in Fed policy rates.
– 0.8% was from the expansion of the term premium.
– Another 0.8% resulted from prepayment risk.
– 0.4% came from changes in the Option-Adjusted Spread (OAS), which measures yield differences due to embedded options like those in mortgage-backed securities.
– 0.3% was from lender fees, and another 0.3% was due to inflation.
These numbers come from Aziz Sunderji at Home Economics, who used data from the Fed, Barclays, and Freddie Mac. It’s tough to nail down precise figures for what influences mortgage rate movements, but these estimates are pretty solid.
Looking ahead, if the Fed starts cutting rates, each 0.25% drop in the Fed’s rates might lower mortgage rates by about 0.125%. Four consecutive cuts could reduce mortgage rates by half a percent. If other factors like inflation or economic confidence also improve, rates could drop even more.
The Mortgage-Treasury Spread, which has historically seen 30-year fixed mortgage rates running about 1.7 percentage points above the 10-year Treasury yield, widened significantly in 2023 due to economic uncertainty, pushing banks to seek higher returns. However, by 2024, this spread began to narrow as banks reduced their lending fees and offered more competitive rates, though it still remained above historical averages.
Even with these potential rate reductions, don’t expect mortgage rates to plummet immediately. It will likely take a few years for the Fed to adjust rates to more borrower-friendly levels. Plus, a quick drop in rates could trigger a surge in housing demand, pushing prices even higher. So, if you’re planning to buy a home, consider how long you’re willing to wait. Like me, when I decided to buy in October 2023 with young children, sometimes moving forward without waiting for perfect conditions is necessary.
Now that you understand what affects mortgage rates, you can make more informed decisions about purchasing a home. And remember, while rates are influenced by many factors, the general expectation is that they will eventually return to a long-term downward trend.
