How the Federal Reserve Affects Mortgage Rates

Although the Federal Reserve doesn’t set mortgage rates directly, it does play an influential role. Mortgage rates are determined by such economic factors as inflation, the strength of the labor market, the trajectory of the economy and the Fed’s monetary policy, which is established by the Federal Open Market Committee.

The Federal Reserve has been busy in 2022 trying to keep inflation in check, but it’s been an uphill battle. With inflation above 8%, the Fed has raised interest rates four times so far. Experts are expecting another rate hike in the wake of the next FOMC meeting, which is scheduled for Wednesday. That would make ripples in every corner of the US economy — and especially so in the housing market.

Read on to learn more about the relationship between the Fed, mortgage rates and the real estate market.

What is the role of the Federal Reserve?

Established in 1913, the Federal Reserve consists of 12 regional Federal Reserve banks and 24 branches and is run by a board of governors, all of whom are voting members of the FOMC, the Fed’s monetary policymaking body. 

The FOMC is responsible for setting overall monetary policy, with the goal of stabilizing the economy and its growth. It does so, in part, by setting the federal funds rate — the benchmark interest rate at which banks borrow and lend their money. When the Federal Reserve raises that rate, banks typically pass on the rate hike to consumers, driving up the overall cost of borrowing in the US. That impacts prospective homebuyers.

“The Federal Reserve is remaining aggressive in raising interest rates to fight inflation and is now, perhaps more significantly, letting their holdings of government and mortgage-backed bonds roll off at twice the pace of the past three months,” says Greg McBride, chief financial officer of Bankrate, CNET’s sister site. “Both of these factors are suggestive of further increases in mortgage rates, at least until inflation slows materially,” he adds.

Factors that influence mortgage rates

Macro factors 

Mortgage rates are at their highest levels since 2008, having surpassed 6%, thanks to Fed policies, the overall state of the economy, persistent inflation and the strength of the job market. If the Fed raises interest rates, it doesn’t mean that mortgage rates will rise in lockstep — because the mortgage market may have already factored in the anticipated increase. “Mortgage rates won’t move in response to this rate hike, but will respond to changing expectations of inflation, interest rates and health of the economy,” says McBride.

Still, mortgage rates have more than doubled to roughly 6% since the beginning of the year. A $500,000 30-year fixed mortgage at a 6.5% interest rate translates to a monthly payment of around $2,900; with a 3.5% interest rate, the monthly payment is $2,200.

Micro factors 

But there are other factors that impact mortgage rates. When loan volume slows, lenders slash rates and loosen their credit requirements. Borrowers with a subpar credit score may actually have a better chance to qualify for a mortgage in a higher rate environment.

When it comes to how a bank decides to make a loan, macroeconomic factors are only one part of the equation. There are a handful of much more specific factors that determine your particular mortgage interest rate. These include:

How the Fed’s decisions influence mortgage rates

Though the Fed doesn’t set mortgage rates directly, its decisions about the federal funds rate eventually impact mortgage rates and the broader housing market. “Generally, when the Fed raises the federal funds rate, that causes other rates in the economy, such as mortgage rates, to go up as well,” says Taylor Marr, deputy chief economist at Redfin, a real estate brokerage. 

When the Fed makes borrowing more expensive, fewer people borrow. That tamps down demand for goods and services, including homes. And that’s why there’s a potential silver lining in a rate hike for some prospective home buyers.

Things to consider if you’re shopping for a mortgage

But higher mortgage rates will take a toll on many borrowers. “The increase in mortgage rates since the beginning of the year has been equivalent to a 28% increase in home prices — and that’s on top of the already heady appreciation seen the past couple of years,” says McBride. 

Although it’s tempting to wait out higher mortgage rates with talk of a potential recession on the horizon, it’s risky to try to time the market and wait for mortgage rates or home prices to drop. Even if home prices depreciate and mortgage rates rise, as is expected, you could still end up with a higher monthly mortgage payment despite getting a good deal on your home.

“Higher rates just means homes will become more unaffordable for buyers,” says Marr.

Regardless of what’s happening with the economy, the most important thing to consider when shopping for a mortgage is making sure that you can comfortably afford your monthly payments. Keeping your day-to-day financial life healthy is what matters the most when making a significant financial decision such as buying your first home. Make sure to always shop around and compare mortgage lenders to ensure you’re getting the best rates and terms available to you. 

How rising interest rates impact your home equity

If you already own a home, mortgage rate fluctuations won’t impact you as much as borrowers applying for a new mortgage. But they can impact your home equity. What’s more significant for homeowners shopping for home equity and home equity lines of credit, or HELOCs, is the prime rate — another baseline rate banks use for lending.

With mortgage rates at more than 6%, a cash-out refinance won’t make financial sense for most homeowners who already locked in lower mortgage rates during the pandemic. In a rising interest rate environment, home equity loans and HELOCs can be a good option for financing. You can borrow against your home equity at a relatively low interest rate, and with a home equity loan, you can lock in a fixed interest rate so you don’t have to worry about the Fed’s next rate hike.

As a homeowner, keep in mind that although mortgage rates may not directly impact you, if you’re trying to sell your home, higher rates could limit the number of would-be homebuyers in your local market, cautions McBride.

The bottom line

When the Federal Reserve raises the benchmark interest rate, it indirectly pushes mortgage rates up. Mortgage rates have more than doubled since the beginning of this year and have surpassed the 6% mark. Higher mortgage rates make buying a home more expensive. So if you’re shopping for a mortgage, make sure to compare the rates and terms being offered to you by banks and lenders. The more lenders you interview, the better your chances are of securing yourself a lower mortgage rate, especially in today’s rising interest rate environment.

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