How the federal funds rate affects mortgage rates

The federal funds rate is an important influence on mortgage interest rates. As the central bank of the United States, the Federal Reserve adjusts the federal funds rate to keep the economy on a steady path. Understanding why the federal funds rate is significant can provide insight into overall mortgage interest rates.

What is the federal funds rate?

The federal funds rate is the rate at which federally insured banks borrow money from each other overnight. Calling it a “rate” is a bit of an oversimplification because the rate is negotiated between the individual banks when the transaction is made. More accurately, the federal funds rate is a range within which banks can trade funds.

When it gets more expensive for banks to borrow money for their daily operations, that cost is passed on to their customers. When borrowing gets cheaper, banks can charge lower interest rates and still make money. The significance of the federal funds rate is that lenders use to set their prime rate, which is the interest rate given to their most qualified clients. From there, rates are set for everything from credit cards and personal loans to vehicles and mortgages.

In practice, a margin is added to the federal funds rate to get the prime rate. A hypothetical bank might set its prime rate as the federal funds rate plus 2%. From there, individual offerings are going to vary. The lender’s most qualified credit card clients might receive a rate that’s the prime plus 17%. Those with riskier or thinner credit profiles might see rates of prime plus 22%.

In the past, banks were required to keep a certain percentage of their funds in Federal Reserve accounts to provide a sort of cushion. They would trade the excess with other banks who needed the funds to cover operations. In recent years, the Fed has done away with this reserve requirement, so lending among banks can happen a little more freely.

How does the fed funds rate work?

The range for the federal funds rate is determined by the Federal Open Market Committee, which reviews economic data, information on business conditions, and world events. The panel meets eight times a year to set a range for the federal funds rate, among other topics. Members also set a discount rate at which banks can borrow. They want the economy to keep growing without inflation getting out of hand.

The voters are seven members of the Federal Reserve board of governors, the president of the Federal Reserve Bank of New York, and four of the presidents of the remaining Federal Reserve branches, who rotate voting privileges each year.

While they don’t set the federal funds rate directly, they hold a reserve of government securities, including U.S. Treasuries. Government securities are U.S. government debt. By setting the price that it will accept for the securities in the open market, the movements of the Fed have an impact on what the effective federal funds rate will be.

How is the fed funds rate determined?

While it might make the jobs of Fed officials easier, there’s no formula for setting the federal funds rate. It’s up to the judgment of FOMC members, who balance labor market and inflation goals that are often in opposition. However, members are pretty open about what they consider:

• Inflation. The Fed’s stated goal is to have yearly price growth around 2%. This is enough to convince people to buy now, which keeps the economy going, but not so much that it makes the money people have earned worth substantially less.
• Employment rates. It’s counterintuitive, but if you’re the Fed, there is such a thing as a labor market that’s too good. If enough people are employed, that it makes it hard to attract and retain talent, and wages tend to increase. If people have more money to spend, inflation goes up as companies raise prices. On the other hand, higher rates to control inflation tend to push up unemployment, so it’s a tightrope walk.
• Gross domestic product growth. GDP is the total value of all goods and services produced within the country. Healthy economies see their production grow moderately each year. If growth stops or slows over a sustained period, it’s an indicator of potential recession. When things are going well, the economy is said to be expanding.
• Fiscal policy. When the Fed sets the federal funds rate, it’s trying to control the amount of money circulating in the economy through interest rates, which is monetary policy. But fiscal policy, which turns on the decisions of elected officials, also has a huge impact on your pocketbook through things like taxes and tariffs. Occasionally, the government also will use stimulus payments to provide targeted relief or provide a broad boost to the economy.
• Global economic conditions. Central banks set monetary policy for their own countries. But nothing exists in a vacuum. Because global trade plays such a big role in the macroeconomy, federal officials pay close attention to economic decisions and geopolitical developments around the world.

Fed funds rate historical trends and effects

For going on close to two decades now, the Fed has been more aggressive than they have historically been in responding to recessions, which has affected the primary mortgage market. Prior to 2008, the federal funds rate range almost never had a zero in front of the decimal. You can track the patterns back a long way because the effective federal funds rate where most banks end up trading has been published since July 1954.

In 2007 – 2008, the Federal Reserve responded to a major financial crash and recession. They slashed the federal funds rate to a range of 0% – 0.25%. The idea behind this is that cheaper borrowing stimulates spending patterns.

It stayed that way until the end of 2015, but everything is cyclical. If rates stay zero forever, it limits the Fed’s options in the next situation. Officials started a pattern of rate increases that lasted until 2019. They had to slow walk some of these efforts because in 2016, Britain unexpectedly voted to leave the European Union. Historically, uncertainty isn’t a good thing in financial markets.

In 2019, citing concerns about global economic growth and consistently low inflation, the Fed began a pattern of decreases that only accelerated as rates were slashed to near zero during the pandemic.

In March 2022, the Fed began consistently raising rates to rein in inflation. Rates increased 11 times between 2022 – 2024. The effects of recent fiscal policy decisions by the U.S. government remains to be seen, but the Fed is consistently trying to balance the labor market with inflation levels.

Inflation remains a concern, but in September of last year, the Fed judged that things were headed in the right direction. Officials lowered the target range for the federal funds rate three times trying to find the new neutral level for rates.

When the fed funds rate increases

There’s not always a perfect one-to-one relationship, but when the Fed hikes rates, consumer rates tend to go up across the board. Shorter-term variable rates for things like credit cards are affected first, but it still has an impact on auto and mortgage loans.

Higher rates discourage borrowing. If people have less money in their pocket, they’ll think twice about spending extra on that cherry-dipped ice cream cone. In the aggregate, less spending should cause businesses to lower prices, which brings down inflation. But it’s easy to go too far because this can lead to less business investment, which means the potential for layoffs and tipping the economy into a recession.

When the fed funds rate decreases

When the Fed funds rate decreases, borrowing money becomes cheaper. People are freer to spend if they have more resources. Businesses also invest, which can lead to more hiring. Consumer spending being a major driver of the economy, things should start to pick up. But too much inflation can cause prices to go sky high if not handled carefully.

How does the fed funds rate affect mortgage rates?

Because the market as a whole responds to the actions of the Fed, changes to the federal funds rate always have some sort of effect on mortgage rates. Regardless of whether you’re buying a home or deciding to refinance your current one, understanding existing market dynamics can help you balance timing and your personal goals to take the opportunity when you’re ready.

Fixed-rate mortgages

Mortgages are more tied to long-term Treasuries because investors are trying to project inflation out as much as 30 years from now. But there’s still an impact. Of course, this is limited to new fixed-rate mortgages.

When the Fed is buying Treasuries in the market, mortgage-backed securities are also included in the bond market, so the price for U.S. Treasuries affects the yield for mortgage bonds. Being in a similar asset class can mean competing for investment dollars. In general, the spread between the 10-year treasury yield and the 30-year fixed mortgage is around 2%. Mortgage rates are on the higher side because of the longer term.

Adjustable-rate mortgages

Because adjustable-rate mortgages have interest rates that periodically change, these rates are more closely affected by short-term changes to the federal funds rate. One of the ways the Fed influences the going trading rate for Fed funds is through their own trading of Treasury securities.

Two of the major indexes for ARMs are the secured overnight financing rate and the 1-year constant maturity Treasury. Both indexes are based on U.S. Treasury trades. In this case, the actions of the Fed have a more direct influence.

Fed funds rate FAQs

Let’s try to answer your burning questions regarding the federal funds rate, the impact on the economy, and mortgage rates.

How often does the Federal Reserve change the fed funds rate?

The FOMC has eight scheduled meetings per year, with the ability to meet on an emergency basis as warranted. Of course, if they see no need to make changes, they may go years without touching the target. Or it could change every meeting for a couple of years. It just depends.

What’s the difference between the federal funds rate and the discount rate?

The federal funds rate represents the interest lenders charge each other for their short-term overnight loans of excess reserves. The discount rate is how much the Federal Reserve charges to borrow from the Fed itself. To borrow, lenders pledge collateral.

Can the federal funds rate affect my current mortgage?

The federal funds rate potentially impacts your existing mortgage. If you have an ARM, any adjustments are based on current market rates, which are affected by the level of the federal funds rate. If you have a fixed-rate mortgage, you should be in the clear. The interest rate doesn’t change for as long as you have the loan.

The bottom line: Watching the Fed can ready you for opportunity

Understanding the way the federal funds rate moves can help you take advantage of market opportunities while being mindful of your goals in buying or refinancing. While the two don’t have a direct relationship, there’s a correlation between mortgage rates and the federal funds rate. If it’s on the way up, mortgage rates tend to be higher. If they’re going down, mortgage rates are likely to follow.

We could write for hours about economic theory, but no one wants that, and every situation is different. If you’re curious about the kind of rate you can expect, the only way to know for sure is to take the first step. Apply online today!