The influence of the Federal Reserve on home loans unraveled:

Going with the Flow: How the Fed's Monetary Policy Affects Mortgage Rates

Chatty break-down of how the Federal Reserve's decisions can impact the mortgage rates you see:

The Fed's recent gathering

At their meeting on June 17-18, the Federal Open Market Committee (FOMC) decided to keep their benchmark interest rate static at its current range of 4.25-4.5 percent—this makes their fourth meeting in a row with no change. The board appears content to keep a vigilant eye on things for now.

In the words of Odeta Kushi, deputy chief economist at First American Financial Corporation, "Inflation is finally making progress, but it's persisting obstinately above the Fed's two percent target, and the labor market remains robust. This leaves the committee in no real hurry to reduce rates."

During this meeting, the FOMC also presented their summary of economic projections, projecting the year's median Federal funds rate to be 3.9 percent. This implies a cut could be on the horizon later in the year, but just when?

According to Dr. Selma Hepp, chief economist for Cotality, "My guess is December." Hepp believes that the FOMC will start signaling a rate cut in September, but only if it happens, it won't be until later in the year.

The FOMC will reconvene on July 29 and 30, marking their last chance to adjust rates before Labor Day.

The Dance between the Fed and Mortgages

The U.S. Federal Reserve sets the borrowing costs for shorter-term loans by moving its federal funds rate. This rate sets how much banks pay each other in interest to borrow funds on an overnight basis from the reserves they keep at the Fed. While this rate differs from the rate you pay for a mortgage, they are connected. Banks' borrowing costs often influence your costs when taking out a mortgage.

In 2022 and 2023, the Fed raised this fundamental interest rate to help curb inflation—a move that increased the costs for Americans to borrow money or take out credit. However, there are moments when mortgage rates seem immune to the Fed's decisions. While the Fed slashed the rate three times at the end of 2024, mortgage rates remained high or even rose.

This seeing-eye-drift is because fixed-rate mortgages, the most common type of home loan, track the 10-year Treasury yield instead of the federal funds rate. When the 10-year yield shifts up or down, fixed mortgage rates mimic the pattern. However, your mortgage rate will be higher than the 10-year yield by an amount called a spread or margin.

Typically, the gap between the 10-year Treasury yield and the 30-year fixed mortgage rate ranges between 1.5 to 2 percentage points. For much of 2023 and 2024, this gap expanded to 3 percentage points, making mortgages more expensive. This lag between the markets was largely due to added risk in the marketplace due to rapidly rising rates.

The rhythm of mortgage rates

Mortgage rates are also impacted by:

Inflation: Generally, when inflation picks up, so do fixed interest rates.
Supply and demand: When demand for mortgages outweighs supply, lenders raise rates to dampen demand. When demand is low, rates often decrease to lure more customers.
Secondary mortgage market: Here, investors buy mortgage-backed securities. High investor demand usually leads to lower mortgage rates, and when investors aren't buying, rates might increase to attract them.

The Fed also deals in debt securities, which helps propel the flow of credit and has a broader impact on mortgage rates.

How the Fed interacts with Adjustable Rate Mortgages (ARMs)

Although fixed-rate mortgages dominate the U.S. home financing sector, some Americans prefer adjustable-rate mortgages (ARMs), which have interest rates that change annually or semi-annually. The Fed's decisions can have a more direct impact on ARMs.

Specifically, the rates on ARMs are often tied to the Secured Overnight Financing Rate (SOFR). Changes in the federal funds rate affect the SOFR, which in turn can push ARM rates up or down.

In short, if the Fed raises the federal funds rate, your ARM rate will increase at the next adjustment.

Historic Fed moves that influenced mortgage rates

In response to the economic repercussions of COVID-19, the Fed cut the federal funds rate to nearly zero. Although 30-year mortgage rates didn’t plummet to the same degree, they did reach record lows. The average 30-year mortgage rate bottomed out at 2.97 percent in February 2021, according to Bankrate data.

The Fed started raising their rate consistently starting in March 2022, as inflation picked up and the U.S. was moving beyond the pandemic. The federal funds rate reached 5.33 percent in August 2023, remaining unchanged until the end of September 2024. As the funds rate went up, so did mortgage rates, with the 30-year rate exceeding 8 percent in October 2023.

Though the Fed reduced its rate three times at the end of 2024—at their September, October, and December meetings, a total of 100 basis points—mortgage rates stayed at lofty levels, often averaging above 7 percent. However, recent economic uncertainties have spurred slightly lower rates, which currently average just below 7 percent.

What to ponder when securing a mortgage

Despite the Fed's current policy, the best strategies for locking in the lowest mortgage rate remain the same:

Maintain top-notch credit.
Keep your debt minimal.
Aim for the largest down payment possible.
Shop around for mortgage deals.

When comparing rates, scrutinize the APR, not merely the interest rate—some lenders advertise low interest rates but offset them with high fees. Knowing your APR will help you grasp your true, all-in cost.

The influence of the Federal Reserve on home loans unraveled: