Let’s break down how mortgage rates work. Many people think the Federal Reserve, or the Fed, controls these rates, but that’s not entirely true. The Fed does have some influence, but it’s the bond market that calls the shots.
The Fed manages the Fed Funds rate, which is the rate banks use for overnight lending. This rate is at the shortest end of what’s called the yield curve. When this rate goes up, it impacts rates for longer periods. For instance, if you can get a 5% return from easily accessible money market funds, you’d want a higher interest rate for longer-term Treasury bonds to make it worth tying up your money. The bond market then decides if the Fed’s interest rate decisions make sense, leading to different yield curve scenarios.
Mortgage rates actually follow the 10-year Treasury bond yield more closely than the Fed Funds rate. So, let’s dive into what influences mortgage rate changes. This understanding will help you make smarter real estate investment decisions.
In early 2022, the Fed started increasing interest rates to combat inflation, which had hit a high of 9.1% by mid-year. After 11 rate hikes, mortgage rates also went up significantly. Let’s look at what caused this rise, which saw mortgage rates jump from 3% to 8%.
Out of this 5% increase in mortgage rates:
- 2.5% came from changes in the Fed’s policy rates.
- 0.8% was due to the expansion of the Term premium.
- Another 0.8% was driven by prepayment risk.
- 0.4% resulted from changes in the Option-Adjusted-Spread (OAS), which measures the yield difference between a bond with an embedded option and Treasury yields.
- 0.3% was due to lender fees.
- The final 0.3% was influenced by inflation.
These figures are estimates by Aziz Sunderji from Home Economics, who analyzed data from the Fed, Barclays, and Freddie Mac. While it’s impossible to give exact percentages for the factors influencing mortgage rate changes, these estimates are considered pretty accurate.
So, what happens to mortgage rates if the Fed starts cutting rates by the end of 2024 or in 2025? The analysis suggests that every 0.25% cut in the Fed’s rates could reduce mortgage rates by about 0.125%. If the Fed makes four consecutive 0.25% cuts, leading to a total 1% reduction in the Fed Funds rate, mortgage rates could drop by 0.5%.
Mortgage rates could potentially drop even more if other factors also decrease. These could include lower inflation expectations, increased competition, and more confidence in the economy’s resilience.
The latest market expectations for the Fed Funds Rates through April 2026 suggest a delay in anticipated rate cuts due to higher-than-expected inflation data in early 2024. However, if the Fed adjusts rates based on this revised outlook, mortgage rates could drop by 0.25% by the end of 2024 and by 0.65% by the end of 2025.
Another factor that could drive mortgage rates lower is the mean reversion of the spread between the average 30-year mortgage rate and the 10-year Treasury rate, known as the Mortgage-Treasury Spread. Since the end of the Great Recession, the 30-year fixed mortgage rate has typically been 1.7 percentage points higher than the 10-year Treasury bond yield. However, this spread widened to over 3 percentage points in 2023 due to more volatility and economic uncertainty. In 2024, we’ve seen this spread decrease to around 270 basis points as banks lower their lending fees and offer more competitive mortgage rates.
While the U.S. economy is strong, it’s unlikely that both the Fed Funds rate and mortgage rates will rise much further. Several factors contribute to this assessment: inflation has already peaked, the S&P 500 is trading at more than 20 times forward earnings, the risk-free rate exceeds inflation by at least 1%, and the level of U.S. government debt is becoming increasingly burdensome.
Without any rate cuts by the end of 2024, the annual interest payment on U.S. Treasury debt could skyrocket to $1.6 trillion. This huge figure highlights the importance of carefully managing interest rates to lessen the impact on government finances.
If you’re hoping for a drop in mortgage rates due to upcoming Fed rate cuts, manage your expectations. The Fed’s influence on mortgage rates is limited to about 50%, and it could take a couple of years or even longer for the Fed to reduce rates to levels that are more borrower-friendly.
Given the significant demand for real estate due to high mortgage rates since 2022, the Fed can’t make rapid cuts. This could trigger a surge in demand, further driving up home prices.
So, consider how long you’re willing to wait before buying your dream home. The longer mortgage rates stay high, the bigger the pent-up demand. Life goes on, after all – people get married, have kids, relocate for jobs, get divorced, and so on.
As for me, I didn’t want to put my life on hold. When I bought my home in October 2023, my kids were three and six. I wanted to move forward with life as soon as possible. I knew that once they grew up, I wouldn’t have as much time to spend with them.
Now that you understand the factors that affect mortgage rates, hopefully, you’ll make a more rational home buying decision. As for where interest rates will go in the long term, I believe they’ll eventually revert to their 40-year downward trend.
So, did you know that the Fed is only partially responsible for the rise and fall of mortgage rates? Do you think the Mortgage-Treasury Spread will revert to its long-term mean of 1.7 percentage points? What other factors do you think affect mortgage rates?
