The Federal Reserve’s Influence On Mortgage Interest Rates: What Home Buyers Should Know
Kevin Graham6-minute read
November 22, 2022
The interest rates that lenders use for mortgage loans may seem a bit arbitrary to potential home buyers. In reality, a number of factors determine mortgage rates. Some of them are personal, such as your credit score and the amount of your down payment or home equity. However, some external factors – such as base interest rates set by the Federal Reserve – are out of your control.
Let’s examine how the Federal Reserve influences mortgage rates through its policies. But first, let’s set the stage with some important background info.
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What Is The Federal Reserve?
Established by Congress and President Woodrow Wilson near the end of 1913, the Federal Reserve is the central bank of the United States. The Federal Reserve Act established a few primary goals for the bank, and these are still its purpose today.
One mission of the Federal Reserve is to create an environment that leads to as many people being employed as possible. The Federal Reserve also seeks to stabilize prices for goods and services, and moderate interest rates over time. The last of these goals has a direct impact on the other two.
In addition, the Fed serves as a key regulator for most of the U.S. banking system. Up next, we’ll focus on how the mission of achieving maximum employment and stable prices relates to interest rates.
The Federal Open Market Committee (FOMC) is the chief decision-making board within the Federal Reserve that sets monetary policy aimed at reaching 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.
How The Federal Reserve Generally 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. The second is its direct influence on mortgage rates with its purchase and sale of mortgage-backed securities (MBS).
The FOMC has direct control over the federal funds rate, which is the rate at which banks borrow from each other when they need funds overnight. As of this writing in October 2022, the rate is in a range between 3% – 3.25%.
This rate typically has the most influence on short-term credit with variable interest, such as a consumer credit card. In this case, the federal 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 federal funds rate and mortgage interest rates often move in the same direction.
How Does The Federal Reserve Affect Mortgage Rates?
In addition to the actions it takes with the federal funds rate, the Federal Reserve has a much bigger impact on mortgage rates. This is because the Federal Reserve began buying at least $10 billion worth of agency MBS per month starting in February 2022. Before that, MBS buying was even higher.
To get a handle on inflation, the Federal Reserve began selling bonds back into the market in May 2022. We’ll get into what this means for mortgage rates later on.
To understand why this matters and how it influences rates, let’s take a brief step back and see 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 or Freddie Mac 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 together 1,000 loans that have down payments of at least 10% and qualifying credit scores of at least 680. In this way, mortgage rates are dependent on two factors. One is the appetite of investors for higher risk but also higher return investments like stocks versus the relative certainty of bonds at a lower return.
The Federal Reserve bond buying helped mortgage rates stay lower than they otherwise would be because MBS sellers always knew they could find a buyer. Now that the Fed is selling bonds back into the market, it would be reasonable to expect that rates would be up because no single investor is going to buy at that volume and they’ll expect a higher yield.
Secondly, your credit qualifications provide a level of certainty or uncertainty about how good of an investment this is going to be.
How Does The Federal Reserve Affect The Housing Market Demand?
The Federal Reserve had been boosting the market demand by buying 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 were 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.
Of course, there’s a flipside to the relationship between bonds and mortgage rates. As the Fed stops buying and even begins to sell some of its holdings, mortgage rates have gone up to entice buyers to 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 that makes them a more competitive option.
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 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 raises interest rates if it’s 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 have already saved isn’t worth as much if there’s a lot of money around. But it’s a balance. The scales have tipped toward higher inflation recently.
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.
Also, as much as people may hate paying more in interest to borrow money, they like earning more on the money they have in the bank, which tends to happen in an environment where interest rates are rising.
How Do Fed Interest Rates Affect 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 loan in the same way it might with variable-rate credit cards. Sometimes, mortgage rates even 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, the prime rate 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 in 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 The Federal Reserve Affects You
The Federal Reserve’s decisions on short-term interest rates widely impact interest rates for consumer credit or loans, because lenders tend to pass on costs and also cost savings over time.
We’ve taken a close look at how the Fed’s moves impact mortgage rates. If you see a lower rate that might help you save money on a mortgage refinance, for example, there’s a good chance that lower short-term interest rates and the Fed bond buying program have something to do with it.
Of course, other factors also influence whether you’re getting a good mortgage rate. These include annual percentage rate (APR), which you might want to take a look at. The bigger the difference between the APR and base interest rate advertised, the more you can expect to pay in closing costs.
The Bottom Line: The Federal Reserve’s Decisions Can Impact 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 might think, so achieving a goal in one area can impact all the others.
The Federal Reserve likes to keep interest rates for borrowed funds relatively low because it encourages buying, which keeps the economy going. However, the Federal Reserve must balance this against inflation and the desire for money savings. This leads to a push-pull when raising and cutting interest rates.
Because housing is such a critical part of the economy, the Federal Reserve wants to keep housing affordable and mortgage rates relatively low. To that end, the Federal Reserve has been buying lots of MBS, which helps mortgage rates stay down.
Now that you know more about the relationship between the Federal Reserve and mortgage rates, you can apply online and get started if you see a rate you like and you’re ready to refi or buy a home. You can also give us a call at (833) 326-6018.
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