The Federal Reserve And Its Impact On Mortgage Interest Rates
One of the Federal Reserve’s (Fed) monetary policy functions is promoting stable prices. It does this primarily by influencing interest rates through setting the target range for the federal funds rate. Although having no direct correlation, the federal funds rate impacts the cost of borrowing money across the economy. Let’s examine the effect of the Federal Reserve on mortgage interest rates.
What Does The Federal Reserve Do?
The Federal Reserve System is the name for the central bank of the United States. It’s heavily involved in how our economy functions. It has five big mandates:
- Conducts monetary policy: This is all about maintaining price stability and creating an environment conducive to as high a level of employment as possible.
- Promotes financial system stability: Officials seek to contain risk to the financial system and make sure things function smoothly.
- Checks on safety and long-term viability of individual financial institutions: This is done through a combination of monitoring and enforcement of regulations.
- Ensures payment systems function smoothly: Services provided to banks as well as the U.S. government make certain that your money gets where you intend it to go.
- Works to facilitate consumer protection and community development: There’s supervision of financial institutions on the consumer’s behalf, as well as work for community economic development.
By monitoring financial institutions and implementing certain measures, it protects our financial system’s general stability.
The Fed makes decisions that influence important credit markets, like mortgages and auto loans. However, it can’t dictate the interest rates that your lender or bank charge you. The only interest rate directly set by the Fed is the discount rate where it lends directly to banks. Otherwise, it only sets target ranges for banks to borrow from each other. More on that later.
Although there are limits to what the Fed can do, there are times when it will step in in the interest of steadying the markets. It did this in both the 2020 and 2008 recessions through the purchase of mortgage bonds to provide liquidity in the housing market and jumpstart the economy through affordable borrowing.
The Federal Reserve’s overall purpose is to help the U.S. economy run smoothly and protect the public interest. In practice, this means that the Federal Reserve strives to create an economic environment in which unemployment is low, prices are stable and interest rates are modest.
A key entity within the Federal Reserve is the Federal Open Market Committee (FOMC). The FOMC makes decisions for the Federal Reserve regarding its monetary policy. It sets the target for the federal funds rate and controls the operations of the Fed as a market participant.
History Of The Federal Reserve And Mortgage Industry
Only individual lenders set mortgage rates. However, the Federal Reserve does have an influence on these rates. To understand why, it helps to have a sense of the history between the Federal Reserve and the housing industry.
Depending on the year, housing contributes anywhere between 15% – 18% of the total economy, according to an estimate from the National Association of Home Builders. Residential investment alone makes up 3% – 5%. Because it makes up such a huge proportion of the economy and people’s budgets, the Fed has an interest in seeing to it that there’s no catastrophic crash in the sector.
As a means of helping the economy recover from the financial crisis in 2008 and avoiding a more calamitous economic meltdown in the early months of the pandemic, the Fed took two consequential actions: It slashed the target for the federal funds rate to near zero. It also bought heavily into mortgage-backed securities (MBS), which helped keep mortgage rates low.
How Do Fed Rates Impact Mortgage Rates?
While the target for the federal funds rate has no direct impact on how mortgage rates are set, it does have an influence. We’ll explain this in greater detail in a couple of sections below. The other way the Fed can more directly influence interest rates is through its activity in the market for mortgage bonds.
Federal Funds Rate
The federal funds rate is the rate at which federally insured banks borrow money from each other overnight to cover short-term funding operations. The Fed sets a target range for this rate, but the rate is negotiated by the banks themselves in individual transactions. The range isn’t binding, but on a practical level, the target range affects everything from credit cards to mortgages.
Although the federal funds rate certainly influences the direction of interest rates and the economy overall, the impact is greater on credit cards, where balances turnover every month, than on longer-term funding like auto and home loans.
Federal Rate Vs. Mortgage Rates
The target for the federal funds rate is set by the Fed and generally has a big influence on a variety of consumer lending options. While there’s certainly an impact of the federal funds rate on mortgage rates, mortgage bonds have more of a day-to-day impact on home loan rates for consumers.
For investors in mortgage bonds, the federal funds rate matters because it can impact the level of interest they might receive on other investments, which would impact their appetite for MBS, which could ultimately swing mortgage rates one way or another.
Mortgage rates themselves are set by lenders based on the price they can get for various mortgage bonds. As we’ll see below, mortgage bond pricing is based on a combination of market factors and personal financial risks.
Mortgage bonds, also referred to as mortgage-backed securities or MBS, are many home loans that have been tied together and sold as a single financial instrument. Investors make money back over time as mortgage servicers forward principal and interest payments from clients. The advantage of this for the investor is that there’s a certain expected rate of return.
Typically, these mortgages are sold to a major investor like Fannie Mae or Freddie Mac before being packaged into an MBS, but this doesn’t always have to be the case. Either way, this allows mortgage lenders to recoup their investment and make further loans without having to wait up to 30 years for all the money to come back with interest.
As mentioned earlier, personal factors can play a role in mortgage bonds. There might be an MBS sold that contained 1,000 loans from borrowers with a median credit score of 720 or better and 20% down. That bond would have a lower yield (rate of return) than a Ginnie Mae bond where the median credit score was 600 with 3.5% down because of a lower risk profile.
Beyond personal factors, market appetites also play a role. Generally speaking, if people believe that the economy is doing well, they’ll invest in stocks. These are higher risk investments, but can also offer a higher potential rate of return. If people are more bearish on the economy, they’ll invest in bonds, which offer a consistent rate of return based on the coupon.
The Federal Reserve has also had influence here. Both in 2008 and again in 2020, the Federal Reserve stepped in to become the biggest buyer of most of the mortgage-backed securities issued in the U.S.
Because investors understood there was a willing buyer on the other end, the yield could be lower while still getting purchased. This had the effect of allowing mortgage rates to be lower. Now that cycle is being reversed as the Federal Reserve tries to normalize things to get inflation under control.
The Fed has stopped buying and has even begun selling their mortgage bonds, which has the effect of pushing rates up in order to attract other investors who might be willing to buy the bonds.
The other thing impacting bond yields and rates, particularly right now, is inflation itself. As prices rise across the economy, bond yields generally rise in an effort to make sure that the return isn’t eaten up by price increases. All of these factors impact the yields on mortgage bonds, which are directly correlated with mortgage rates.
What Is The Current Fed Mortgage Rate Today?
The Federal Reserve doesn’t set mortgage rates. Instead, it sets the target range for the federal funds rate, which has an indirect influence on all consumer interest rates, including those for mortgages.
In December 2022, the Federal Reserve made the sixth increase of the year to the target for the federal funds rate. The new range is 4.25% – 4.5%.
Mortgage rates change daily (or faster) and are influenced by both movements in the bond market and the economy. Additionally, different lenders price a borrower’s qualifying rate differently. That said, you can get an idea of our current mortgage rates. Keep in mind, the mortgage rate you'll qualify for is based on the market rate and your personal financial factors.
The Bottom Line
The Federal Reserve has a major impact on consumer interest rates through the target range for the federal funds rate, which it increases or decreases to stabilize prices. Although this is a target range, in practice, lenders pretty much follow the Federal Reserve’s guidance. However, short-term lending like credit cards is more impacted than longer-term lending like mortgages.
Although impacted by the directional movements of the federal funds rate, mortgage rates are directly tied to the appetite for mortgage bonds. In general, the more optimistic people are about the economy, the more they invest in stocks rather than bonds and rates are higher. If people are pessimistic, it’s the other way around. Also, the better your finances, the better the rate.
Now that you know more about how the Federal Reserve can influence mortgage rates, get started if you’re ready to purchase or refinance and like the rate you see. No one knows for sure where they might go in the future. You can also speak with one of our Home Loan Experts at (888) 452-0335.