How the Federal Reserve Impacts Mortgages | Mortgages

At its June 2024 meeting, the Federal Reserve left interest rates at 5.25% to 5.5% and announced that it plans only one rate cut in 2024. Federal Reserve Chair Jerome Powell stated that the Fed has made only “modest progress” toward lower inflation, and the central bank isn’t yet confident that this progress will stick.

For homeowners and potential homebuyers, this means mortgage rates may not be falling anytime soon, either. It’s helpful to understand how Fed policy can impact mortgage rates and what it means for you.

The housing market is sensitive to changes in interest rates. In a high-interest-rate environment, mortgage rates tend to rise, as well. Don’t expect mortgage interest rates to automatically increase, however, when the Fed targets a higher interest rate. In fact, long-term fixed mortgage rates generally react to the same conditions that drive the Fed to make its decisions and not necessarily to a Fed interest rate change itself.

“The Federal Reserve does not directly determine the mortgage rate specifically, but it has tools to indirectly control various interest rates,” says Yong Jin Park, associate professor of economics at Connecticut College. One of these tools is setting the target range for the federal funds rate, which influences short-term lending rates.

Financial institutions establish their own base rate for their lending products, called the prime rate, which is typically set a few percentage points above the federal funds rate. Loans based on the prime rate, including construction loans, some adjustable-rate mortgages and home equity financing, tend to get more expensive when the Fed increases rates.

When setting the benchmark rate, Fed policymakers determine a target range they feel will best balance economic growth and inflation.

“Traditionally, the Fed raises interest rates and keeps them high to slow down economic activities to control inflation,” Park said. The Fed may then decide to lower its benchmark rate “only when there is enough evidence that the inflation is under control,” Park says.

When inflation is persistent, the Fed may have to keep interest rates elevated. “Sticky” inflationary conditions also tend to keep mortgage rates from falling.

Homeowners who have a fixed-rate mortgage won’t see their interest rate change regardless of moves by the Fed. Fixed-rate mortgages have rates and payments that don’t change over the life of the loan.

Prospective homebuyers shopping for a new fixed-rate mortgage could be affected by Fed decisions, however. Rates on fixed mortgages issued by banks topped 7% on average in the first quarter of 2024 as the Fed has maintained a higher-for-longer stance with the federal funds rate.

Adjustable-rate mortgages have rates that can fluctuate along with broader market conditions, including the Fed’s changes to the federal funds rate.

“Homeowners with an adjustable mortgage are likely more directly impacted by the Fed’s policies,” says Danielle Hale, chief economist at Realtor.com. “Many ARMs are tied to the secured overnight financing rate, which does tend to vary with the Fed’s policy rate,” she says. The SOFR is a reference rate that is often used as a benchmark for other variable interest rates.

Adjustable-rate mortgages have introductory rates that are fixed for some period of time – generally one to 10 years, with five years being the most common. After the introductory period ends, the loan begins adjusting according to its terms. Adjustable mortgage rates are tied to short-term indexes like certificate of deposit rates and Treasury bill rates, and those tend to rise along with the federal funds rate.

Home equity lines of credit usually have adjustable interest rates. Therefore, if the Fed raises interest rates, HELOC rates will likely rise, too.

Home equity loans typically deliver a lump sum of funds with a fixed interest rate. If you already have one, your rate won’t change as a result of the Fed’s policy moves. If you’re shopping for a new home equity loan, however, know that home equity rates tend to mirror market trends. Higher overall interest rates mean you’ll likely see higher home equity loan rates, too.

Mortgage rates fluctuate depending on many factors, including economic conditions and investor appetite for mortgage-backed securities, or MBS. MBS are effectively bundles of mortgage loans that pay investors a steady yield.

“When the economy is growing, investors generally have many opportunities to pursue,” Hale says. Therefore, they may be less interested in buying mortgage-backed securities, which are a relatively safe, and thus lower-yielding, investment. If the economy weakens, though, investors may flock to these types of assets, driving rates lower.

You can’t control the U.S. economy, but you can take charge of your finances. If you’re shopping for a new mortgage, home equity loan or HELOC, there are some steps you can take to get a better rate.