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The Federal Reserve’s Influence On Mortgage Interest Rates: What Home Buyers Should Know

Kevin Graham6-minute read

June 19, 2021

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Interest rates can seem like they’re quite literally set out of thin air at times. However, a number of factors can play a role. Some of them are personal, such as your credit score and the amount of the down payment or equity you have. But the money supply and the policy around it also plays a role. The Federal Reserve is the controller of that money supply.

In this article, we’ll go over how the Federal Reserve influences mortgage rates through its policies. But before we get there, let’s run through a bit of background to set the stage.

The Role Of The Federal Reserve

Established by Congress and President Woodrow Wilson at the end of 1913, the Federal Reserve is the central bank of the United States. The Federal Reserve Act established a few key goals for the bank that still serves as its purpose today.

The missions of the Federal Reserve are to create an environment that leads to as many people being employed as possible, stabilize prices for goods and services and moderate interest rates over time, which has a direct impact on the other two missions.

In addition, the Fed serves as an important regulator for much of the entire U.S. banking system. We’ll focus on the missions of employment and stable prices and how they relate to interest rates for the rest of this article.

The Federal Open Market Committee (FOMC) is the chief decision-making board within the Federal Reserve that sets monetary policy aimed to achieve the Fed’s goals. Its decisions on the movement of short-term interest rates and spending the money under its control have a big impact on many areas of the economy, and mortgage rates are no exception.

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How The Federal Reserve Affects Interest Rates

The Fed holds two main tools it uses to influence interest rates: The first is its direct control of short-term interest rates. It also influences mortgage rates directly with its purchase and sale of mortgage-backed securities (MBS).

The FOMC has direct control over something called the Fed funds rate. This is the rate at which banks borrow from each other when they need funds overnight. The rate is currently in a range between 0% – 0.25%.

This rate typically has the biggest impact on short-term credit with variable interest, such as a consumer credit card. In this case, the Fed funds rate may be added to a margin and personal factors that contribute to your interest rate. And although not directly impacting rates for longer-term loans like mortgages, the two often move in the same direction.

In contrast, the Fed has a much bigger impact right now on mortgage rates. This is because they’re currently buying $40 billion worth of agency MBS per month. To understand why this matters and how it impacts rates, let’s take a brief step back and talk about how an MBS works.

Let’s say you have a 700 median FICO® Score and you close on a conventional mortgage after putting 10% down. To gain funding for making future loans, most lenders sell these loans to a major mortgage investor like Fannie Mae soon after the loan closes. Fannie Mae then makes its money by packaging similar loans up into MBS and selling these to investors in the bond market.

For example, Fannie Mae might put 1,000 loans together that have down payments of at least 10% and the qualifying credit scores of at least 680. In this way, mortgage rates are dependent on two things: the appetite of investors for higher risk but also higher return investments like stocks vs. the relative certainty of bonds at a lower return. Secondly, your credit qualifications show them different levels of certainty that this is going to be a good investment.

The Federal Reserve is boosting the market demand side a little bit right now by buying lots and lots of mortgage bonds. Since you don’t have to offer as high a rate of return when there’s high demand for MBS, mortgage rates are lower than they would be if the Fed wasn’t doing all that buying.

The Fed is very interested in MBS buying because, depending on the year, housing makes up 15% – 18% of overall economic growth depending on the year.

Of course, this has a flipside. If the Fed stops buying and even begins to sell some of their holdings, mortgage rates are likely to go up somewhat unless an equally interested buyer (or several buyers) get in the market for mortgage bonds.

Why The Federal Reserve Cuts Interest Rates

When the Federal Reserve cuts the Fed funds rate, they’re doing so with the intention of spurring economic activity. The theory is simple: If you make money cheaper for banks to borrow, they’ll make it cheaper for consumers to borrow because no one wants to be that much more expensive than their competition.

If it’s cheaper for people and businesses to borrow, they’ll buy more houses and employ more people, taking advantage of the opportunity. A prime example of this in action happened during COVID-19.

Interest rates were cut to near zero in a matter of weeks. Together with quantitative easing measures like the MBS buying program and extension of new credit to businesses, these helped temper of the effects of the economic downturn caused by lockdowns. Housing demand is way up, spurred at least in part by low interest rates.

Why The Federal Reserve Raises Interest Rates

The Federal Reserve would raise interest rates if they were trying to keep inflation, a fancy word for price increases, from running out of control. When rates are low, people borrow more money and there’s more money flying around in the market.

When there’s too much money out there, prices rise rapidly because the money people already had saved isn’t worth as much if there’s a lot of money around. But it is a balance.

The Fed wants a certain amount of inflation annually. You may hear a lot about a 2% goal. A little bit of inflation stimulates the economy by encouraging people to buy goods and services now. This in turn lets companies hire people to produce those goods and services.

You just don’t want to get the point where you’re paying $10 for a candy bar. Every sweet tooth has a price, but I wonder how much I would be willing to pay.

Also, as much as people hate paying more in the form of interest to borrow money, they equally like earning more on the money they have in the bank, which tends to happen in a rising interest rate environment.

The Relationship Between Fed Interest Rates And Mortgage Rates

There’s often a correlation between mortgage rates and the Fed funds rate, but it doesn’t move in lockstep with a longer-term loan like a mortgage in the same way it might with variable-rate credit cards. There can even be times where mortgage rates move in the opposite direction for a short period of time.

Because MBS are traded in the market, mortgage rates are much more influenced by overall demand for bonds. Additionally, stocks and other commodities like oil prices can have an impact on mortgage rates because investments in these areas can affect demand for MBS. If there’s enough demand for stock on a tea company in China, the price of tea in China could affect mortgage rates. A global economy breaks down a lot of the old assumptions.

How Does The Fed Affect You?

The Federal Reserve’s decisions on short-term interest rates impact a ton of interest rates for consumer credit or loans, because lenders tend to pass on costs and also cost savings over time.

We talked extensively about how the Fed’s moves impact mortgage rates. If you see a lower rate right now that you feel like taking advantage of to save money on a refinance, for example, there’s a good chance that lower short-term interest rate and the Fed bond buying program have something to do with it.

Of course, there are other things that go into determining whether you’re getting good mortgage rate. You might want to look at the annual percentage rate (APR). The bigger the difference between the APR and the base interest rate advertised, the more you can expect to pay in closing costs.

The Bottom Line: The Federal Reserve’s Decisions Could Align With Your Home Financing Plans

The Federal Reserve has a rather large mandate, balancing employment with inflation and interest rates. Additionally, these issues are often more interrelated than you think, so the attainment of a goal in one area can impact all the others. There are lots of balls in the air.

The Federal Reserve likes to keep interest rates for borrowed funds relatively low for consumers because it encourages buying, which keeps the economy going. However, this has to be balanced against inflation and the desire for money saved to go further. This leads to a push-pull when it comes to raising and cutting interest rates.

Because housing is such a big part of the economy, the Federal Reserve has an interest in keeping housing affordable and mortgage rates relatively low. To that end, they’ve been buying tons of MBS, which helps keep mortgage rates down.

Now that you know a little bit more about the relationship between the Federal Reserve and mortgage rates, if you see a rate you like and are ready to refi or buy a home, you can get started online. You can also check out this article to learn how to get the best mortgage rate.

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Kevin Graham

Kevin Graham is a Senior Blog Writer for Quicken Loans. He specializes in economics, mortgage qualification and personal finance topics. As someone with cerebral palsy spastic quadriplegia that requires the use of a wheelchair, he also takes on articles around modifying your home for physical challenges and smart home tech. Kevin has a BA in Journalism from Oakland University. Prior to joining Quicken Loans, he freelanced for various newspapers in the Metro Detroit area.