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How does inflation affect mortgage rates?
Many factors influence your specific interest rate on a mortgage loan, including your credit history, income, the amount you borrow, and the size of your down payment. But even though your unique circumstances may affect the rate you receive, average loan rates across the country tend to rise and fall with inflation. This means even the most well-qualified borrowers receive a higher interest rate during periods of high inflation.
Inflation doesn’t directly impact mortgage interest rates, but the two are related. Understanding how inflation affects mortgage rates can help you make the best borrowing decisions.
Learn more: How are mortgage rates determined?
In this article:
Mortgage rates and inflation
As of December 2024, Freddie Mac reported that the average interest rate on a 30-year fixed mortgage was just under 6.70%. This is an improvement over the average rate of 7.22% in May but still much higher than the 2.65% average rate borrowers saw in January 2021.
These rate fluctuations are partially tied to inflation, which is the steady and general increase of prices over time. Inflation is the reason your grandparents could purchase a home for around $20,000 in the 1960s, which translates to over $200,000 in 2024 dollars.
But inflation doesn’t organically cause interest rates to increase. The Federal Reserve adjusts interest rates in response to inflation.
Read more: Current 30-year fixed mortgage rates
The Federal Reserve’s role in interest rates
Since its founding in 1913 via an act of Congress, the Federal Reserve has been tasked with maintaining economic stability in the United States, specifically regarding inflation. That’s because too much or too little inflation can cause economic distress. When costs rise too quickly under runaway inflation, consumers struggle to afford the necessary purchases.
On the other hand, consumers don’t spend as much money when inflation is low or stagnant, not even when prices are lowered to tempt more people to make purchases. Low inflation can be a sign of tough economic issues, meaning people might be out of a job or facing other financial problems that keep them from buying goods.
Both high and low inflation can be bad for the American economy and the consumer. The Fed works to keep inflation at a healthy rate of approximately 2%, most notably by setting the federal funds rate, which is the interest rate that banks charge when they lend to other banks.
Dig deeper: How the Federal Reserve impacts mortgage rates
What is the federal funds rate?
Banking institutions are required to keep a cash reserve representing a percentage of their total deposits. When they do not have a large enough reserve on any given day, a bank facing a shortfall can borrow from another bank experiencing a surplus. These loans are made overnight simply so the borrowing bank can meet the cash reserve requirements. And just like a consumer loan, the borrowing bank has to pay interest on the loan to the lending bank.
The benchmark interest rate banks charge each other for these overnight loans is called the federal funds rate. When lending to consumers, banks offer interest rates based on the federal funds rate, plus additional interest to ensure they make a profit. That’s why interest on mortgages and other consumer loans are typically higher than the federal funds rate.
Learn more: Fed fund rate predictions for 2024 and 2025
Inflation and the federal funds rate
The Federal Reserve adjusts the federal funds rate to help shape the country’s economy. When inflation is high, the Federal Reserve might increase the federal funds rate in an effort to slow down inflation. Fewer people will borrow money when rates are higher, which can help stabilize inflation.
However, if the economy faces a potential recession because inflation is too low or stagnant, the Federal Reserve will decrease the federal funds rate to encourage more spending. With lower rates, more people are likely to borrow money to buy a home, start a business, or finance a car, thereby spurring economic growth and a healthy level of inflation.
The inflation report and mortgage rates
The Federal Reserve must adjust the federal funds rate in response to economic changes, so it’s impossible to predict where interest rates will go (especially in the long term) since we cannot know future inflation rates. For example, the market downturn that accompanied the onset of the COVID-19 pandemic had a major impact on the American economy — and it was impossible to predict.
However, even though we can’t know what future inflation will be, the Federal Reserve does create a regular inflation report to forecast where the economy will go over the coming year and decade. Though this report obviously can’t guarantee the future, it does use known parameters to set expectations for future inflation. As of November 2024 — the most recent inflation data at the time of writing — the Fed forecast 3% inflation for the coming year. This is based on various factors, such as the Consumer Price Index (CPI) and Personal Consumption Expenditures (PCE) Price Index, two popular tools for measuring inflation throughout the year.
This could be good news for potential home buyers. Consistent lower inflation reports have helped lead to fed funds rate cuts, which could mean lower interest rates on mortgages and other consumer loans.
Learn more: How to get the lowest mortgage rates possible
Interest rates vs. inflation FAQs
How does the inflation report affect interest rates?
Inflation reports such as the Consumer Price Index (CPI) will not directly affect mortgage lenders' interest rates. However, the Fed’s current report forecasts a slowing down of inflation, which will likely lead to the Federal Reserve lowering the federal funds rate. In turn, this should decrease the interest rates offered to borrowers.
What happens to interest rates when inflation rises?
When inflation rates rise, the Federal Reserve generally increases the federal funds rate, which leads to higher consumer interest rates. By increasing interest rates during periods of inflation, the Fed helps to slow rapid inflation to a healthy level.
Will mortgage rates decline in 2025?
It is impossible to know for certain where mortgage rates will go in the future since unforeseen events that affect the economy (like COVID-19) cannot be predicted. Based on the Fed’s current inflation report expectations, however, we’ll probably see lower mortgage rates in 2025 since inflation is also expected to decrease over the next year.
This article was edited by Laura Grace Tarpley.
