How Does the Fed Rate Affect Mortgage Rates?

Nervous buyer surrounded by heads telling her mortgage rates are going up and she needs to buy now

Has a broker, lender or talking head on TV told you to buy an apartment now because interest rates are going up? If so, you need to tell them they’re in the wrong business – they could make billions of dollars with that information!

Mortgage rates are very important for homebuyers and the overall housing market but the interest rates everyone talks about? Not so much. How could rising interest rates not increase your mortgage rate? Let’s find out.

Table of Contents:

Which Interest Rates Are Going Up Anyway?
Why Don’t Rising Interest Rates Matter To Buyers?
Why Doesn’t The Fed Funds Rate Impact Mortgage Rates?
So What Does Cause Mortgage Rates To Change?
How Should Interest Rates Affect Your Home Buying Process?

Which Interest Rates Are Going Up Anyway?

Whenever you hear about interest rates on the news, it’s almost certainly referring to the “fed funds rate.” The fed funds rate is the interest rate banks receive on money held at the Federal Reserve (“the Fed”). You can think of it as the interest rate banks get on their savings account.

The fed funds rate is the Fed’s primary tool for implementing monetary policy. By raising interest rates, the Fed makes it more attractive for banks to save money so they have less money to make loans. Fewer loans means less spending and the overall economy slows.

In other words, when the Fed raises interest rates, they slow the economy down. When they lower interest rates, they speed it up.

Housing is the perfect real world example - if you were offered a loan with a 0% interest rate, you would be more likely to buy, right?

So if the Fed is raising interest rates, isn’t that bad for buyers? Won’t mortgage rates go up? Not exactly.

Why Don’t Rising Interest Rates Matter To Buyers?

Remember the Fed is raising the “fed funds rate.” Did we say anything about mortgage rates? Nope.

This is where most people giving you advice go wrong.

We need to figure out what impact the fed funds rate has on mortgage rates.

Mortgage rates most closing track the 10 Year US treasury. That’s the interest rate the US government will pay you to borrow your money for ten years. Look at this chart of mortgage rates in blue and the 10 Year Treasury in red over the last five years -

Chart comparing the 30 year fixed mortgage rate and the 10 year US treasury rate

Pretty similar, right?

Now what about the fed funds rate? How does that compare to mortgage rates? Here’s the same chart but with the fed funds rate in red -

Chart comparing the 30 year fixed mortgage rate and the fed funds rate

Mortgage rates are about where they were five years ago when the fed funds rate was essentially 0%. In fact when the fed funds rate first started going up, mortgage rates went down.

This will be explained in more detail below but if this is already getting too in the weeds for you, make sure to take away that the interest rates you hear on the news have very little impact on mortgage rates.

Why Doesn’t The Fed Funds Rate Impact Mortgage Rates?

When you take out a mortgage, you’re borrowing money today, a year from now, all they way out to 30 years from now.

At the same time, your bank is lending you money for 30 years from now and needs to consider what else it could do with that money today and over the next 30 years. When banks are considering what interest rate to charge, they’re considering interest rates today as well as in the future.

Consider this scenario:

I’m willing to give you $1 this year, $2 next year, all the way out to $10 ten years from now. If I offered you $10 instead, would you take it? Of course not. You’d get $55 over those ten years.

A 10 Year Treasury does the same thing with interest rates. It takes everyone’s expectations for interest rates today, next year, up to ten years from now and figures out what that is worth today.

So what does a rising fed funds rate mean for mortgage rates? Let’s think through the steps:

  1. Everyone agrees - the Fed is going to raise interest rates (the fed funds rate)
  2. Since everyone agrees, the increase is already included in everyone’s 10 Year Treasury forecasts
  3. Mortgage rates mirror the 10 Year Treasury so the increase is already included in mortgage rates as well

So What Does Cause Mortgage Rates To Change?

One word - expectations.

When everyone starts to think the Fed won’t raise their interest as quickly or aggressively as they previously expected, interest rates go down.

Remember the $1 example above? What happens if instead of $1, you found out the payments were only going up $0.50 each year? You’d be disappointed.

This is why the Fed often increases interest rates and the interest rate on the 10 Year Treasury (and therefore mortgage rates) go down. In fact, since the market is never exactly right, interest rates are as likely to go down as up when the Fed increases interest rates.

How Should Interest Rates Affect Your Home Buying Process?

There are two points when buyers typically think about interest rates - when they’re thinking about buying in general and when they can lock in an interest rate.

For all of the reasons above, do not let anyone tell you to buy now due to interest rates.

However, locking in a rate can be a good idea as it eliminates interest rate risk. Provided your interest rate is locked in with enough time to close, it allows you to know what your monthly mortgage payment will be.

This is a lot of technical information so if it went over your head, don’t worry about it! Get in touch with Yoreevo and we’re happy to answer any questions you have. Yoreevo’s goal is to make home buying easy and transparent while also saving our clients a lot of money with our commission rebates!