The U.S. Federal Reserve cut a key interest rate for the second time in two months. So, interest rates on mortgages should come down along with it, right? Guess again.
After the first cut in September, mortgage rates moved up nearly 50 basis points (or half a percentage point). Moreover, few expect mortgage rates to fall after the most recent cut, once again disappointing those looking to buy a home and prompting questions about what really drives mortgage rates.
A common misconception is that Fed rate cuts automatically mean lower mortgage rates. However, the Fed does not set mortgage rates. Instead, mortgage rates are influenced far more by longer-term Treasury bond yields, which, in turn, are driven by investor expectations of broader economic and financial conditions.
Two primary factors drive mortgage rates:
1. The “base rate”: This rate is tied to yields on medium-term U.S. Treasury bonds, ordinarily 10-year bonds. The 10-year Treasury BX:TMUBMUSD10Y is the risk-free alternative for investors when deciding how much return they want when they buy a typical mortgage — usually in the form of a mortgage-backed security, or MBS.
Unlike the short-term fed funds rate, the 10-year Treasury yield is set by the market, not the Federal Reserve. Private investors determine Treasury yields based on all kinds of factors, including expectations for economic growth, inflation, and future policy changes. Ten-year Treasury yields can and do move independently of short-term rates, as they have in the last month.
2. The mortgage “spread”: This is the premium that investors require to cover the extra risks associated with buying MBS, as well as lenders’ costs to underwrite, originate, and securitize mortgages. Investors, for example, focus on prepayment risk, or the risk that homeowners exercise their right to pay off their 30-year fixed-rate mortgage earlier than the mortgage term, typically via either a refinance or sale of the home. When bond market volatility rises (as it has), prepayment risk rises. Spreads can also widen or narrow based on changes in lenders’ costs.
The spread plus the base rate equals the mortgage rate. Changes to either of these can influence whether mortgage rates rise or fall.
The Fed’s September and November rate cuts had been signaled long in advance, causing investors to plan and act accordingly. So the actual event was already largely priced into 10-year Treasury yields. Then, shortly after the first Fed action in September, strong economic data and labor-market data pointed to a better-than-expected outlook. When paired with market expectations that Treasury issuance may increase in the years ahead, Treasury bond prices dropped, pushing the yield higher. The resulting 0.70% boost in 10-year Treasury yields pushed up mortgage rates rather significantly in a short period of time.
Mortgage rates currently are at roughly 7%. The increase in the 10-year Treasury bond yield was the main reason mortgage rates moved higher. Notably, the spread — the other component of mortgage interest rates — held relatively stable during the same period.
It’s important for mortgage investors, the housing market, and consumers to understand that it is unlikely we will again see the low mortgage rates we had during the COVID-19 pandemic, when a unique combination of monetary and fiscal policy sent rates to near all-time lows.
In fact, current mortgage rates and Fannie Mae’s forecast for 2025 rates are well in line with rates over the past several decades. Since 1990, the 30-year fixed-rate mortgage has averaged 6%. Consequently, recent rate increases might be better viewed as simply a return to historical norms after a relatively brief period of abnormal lows, spurred by a once-in-several-generations pandemic.
The implications are wide-ranging. Mortgage investors favor certainty — but today’s market carries a lot of uncertainty. In addition to the normal uncertainty around Fed rate moves, there is the effect — or lack of effect — of the Fed reducing its large mortgage-backed securities (MBS) portfolio (initially created during the Great Financial Crisis). Also, future regulation changes could provide incentives or disincentives for banks and other investors to hold MBS on their books, moves that could affect MBS prices and attractiveness as investments.
For home buyers, higher rates for longer may continue to weigh down demand and home sales. The Mortgage Bankers Association recently reported that mortgage demand has fallen 41% since rates started rising again in September. As supply continues to be constrained and if rates continue to be in line with historical norms (but higher than during COVID), Fannie Mae economists do not predict any large uptick in home sales in 2025.
For potential homebuyers, the takeaway is that they shouldn’t count on Fed rate cuts to lower mortgage rates. Instead, they should focus on building the strongest possible credit record to qualify for the lowest rate lenders offer. And, as always, first-time buyers should get as smart as possible about the home-buying process so that when the opportunity arises, they can get into a home and mortgage that sets them up for long-term success.
