Why Are Mortgage Rates Rising Despite Fed Rate Cuts?
If you’ve been keeping an eye on the news lately, you might be scratching your head wondering: the Federal Reserve has been cutting interest rates since late 2024, so why are mortgage rates still going up? It’s a confusing phenomenon that many potential homebuyers and investors are trying to understand. Let’s break down what’s really going on behind the scenes and why mortgage rates don’t always move in sync with Fed rate cuts.
Understanding the Federal Reserve and Interest Rates
What Is the Fed Funds Rate?
The federal funds rate is the interest rate at which banks lend money to each other overnight. The Federal Reserve sets this baseline rate to influence the broader economy—by making borrowing more or less expensive, it can help control inflation and encourage or slow down economic growth.
The Fed’s Recent Moves
Starting in September 2024, the Fed began cutting this rate after a long stretch of hikes during 2022 and 2023 aimed at taming inflation. For example, they cut by 50 basis points (0.5%) in September, then by 25 basis points in November and December, bringing the target rate down to around 4.25% to 4.5%.
Why Mortgage Rates Aren’t Directly Linked to the Fed Funds Rate
Here’s the kicker: mortgage rates don’t directly follow the Fed funds rate. When people say “the Fed cut rates, so my mortgage should be cheaper,” that’s a common misconception. Mortgage rates are influenced primarily by the bond market, especially the yield on 10-year Treasury bonds, not the Fed funds rate.
The Role of the Bond Market in Mortgage Rates
10-Year Treasury Yield: The Real Mortgage Rate Driver
Mortgage rates are closely tied to the yield on 10-year Treasury bonds because mortgages are long-term loans similar in length to these bonds. Typically, mortgage rates are about 1.5% to 2% higher than the 10-year Treasury yield to compensate investors for the additional risk of mortgage-backed securities.
How This Spread Works
If the 10-year Treasury yield is 4%, mortgage rates tend to hover around 5.5% to 6%. This spread accounts for risk factors like potential borrower default and prepayment risk. In recent years, this spread has even widened to around 2.5% to 3%, pushing mortgage rates higher even when the Fed funds rate is lowered.
Visualizing the Disconnect
Looking at charts from 2020 to 2024, you’ll notice the Fed funds rate (red line) dropping sharply in 2024, but the 10-year Treasury yield (blue line) and mortgage rates (green line) stay elevated or even increase. This divergence is key to understanding why mortgage rates aren’t coming down like many expect.
Four Key Reasons Mortgage Rates Are Still High
1. Strong Economic Data
In December 2024, nonfarm payroll reports showed stronger-than-expected job growth. A robust labor market signals a healthy economy, which usually means inflation risks persist, prompting investors to demand higher yields on bonds. Strong employment data reduces the likelihood that the Fed will cut rates aggressively in the near future, keeping bond yields and mortgage rates elevated.
2. Inflation Resurgence
Inflation has been stubbornly high, and investors fear it could return with a vengeance. Inflation diminishes the value of fixed-interest payments, so bond investors demand higher yields to compensate for this risk. This drives up the 10-year Treasury yield, pushing mortgage rates higher.
3. Monetary Policy and Market Expectations
The Fed’s dual mandate is to maximize employment and keep inflation around 2%. Although the Fed is cutting rates, markets are skeptical about the pace and scale of these cuts because economic indicators suggest inflation might remain sticky. This disconnect causes bond market yields to rise even as the Fed lowers short-term rates.
4. Government Spending and Debt Levels
High government debt means the Treasury has to issue more bonds. To attract investors amid this oversupply, yields need to be attractive enough. Higher yields on government debt translate into higher rates in the mortgage market as well, since mortgage-backed securities compete for investors’ attention.
What This Means for Homebuyers in 2024
The Tough Reality: Higher Mortgage Costs
If you’re on the fence about buying a home, the Fed’s rate cuts don’t necessarily mean cheaper mortgages. With mortgage rates hovering around 6% or higher, borrowing money remains expensive compared to previous years. This impacts monthly payments and overall affordability.
Historical Context: How Do Current Rates Compare?
Mortgage rates today might feel high, but historically they’re not unprecedented. In the 1990s, rates often exceeded 10%, and in the early 1980s, they went above 16%. However, what’s unique now is the relationship between wages, house prices, and mortgage rates.
House Prices vs. Wages: A Growing Gap
The average home price in the U.S. is now over seven times the median household income, a ratio last seen during the 2006 housing bubble. Back then, loan-to-value ratios were often 80-85%, meaning buyers owed most of the home’s value. Today, average loan-to-value ratios are around 45%, indicating buyers have more equity upfront, but affordability remains a challenge.
Price Per Square Foot Tells the Real Story
Some argue that homes are bigger now, so naturally prices would be higher. But price per square foot shows the true increase in housing costs, which has skyrocketed over the past two decades, reflecting how real estate is deeply tied to the broader financial system and inflation.
How Could Mortgage Rates Come Down?
1. Inflation and Employment Slowdown
If inflation cools off and the labor market weakens, bond yields could drop, narrowing the spread between Treasury yields and mortgage rates. This scenario would make borrowing cheaper and could lower mortgage rates.
2. Economic Weakness Spurs Fed Action
A weaker economy typically pushes the Fed to cut rates more aggressively to stimulate growth. This could eventually lower both the Fed funds rate and bond yields, thereby reducing mortgage rates.
3. Narrowing Treasury-Mortgage Spread
If investors perceive less risk in mortgage-backed securities, the spread between Treasury yields and mortgage rates could narrow from current elevated levels back toward historical norms (1.5%-2%). This alone could bring mortgage rates down even if Treasury yields remain somewhat elevated.
Should You Buy Now or Wait?
Pros of Buying Now
- Locking in a mortgage rate before potential future increases.
- Avoiding further home price inflation, which tends to happen when inflation is high.
- Starting to build equity instead of paying rent.
Cons of Buying Now
- Higher monthly mortgage payments than in recent years.
- Affordability challenges due to high home prices relative to income.
- Risk that mortgage rates could come down if economic conditions change.
Renting vs. Buying: The Ongoing Debate
Many potential buyers are reconsidering renting due to high mortgage costs. Renting offers flexibility and lower upfront costs but doesn’t build equity. Buying is a long-term investment but requires financial stability and often higher monthly expenses.
Final Thoughts: Navigating Today’s Housing Market
Mortgage rates rising despite Fed rate cuts is less about monetary policy and more about what the bond market, inflation, and economic data are signaling. For potential homebuyers, it’s essential to understand these dynamics rather than just focusing on headline Fed announcements. The housing market is complex, and affordability is influenced by multiple factors beyond just interest rates.
If you’re considering buying a home in this environment, it’s wise to consult with financial advisors, monitor economic indicators, and be realistic about what you can afford. Remember, the Fed’s job is to balance inflation and employment, but market forces ultimately drive mortgage rates.
FAQs
Q: Why don’t mortgage rates follow the Fed funds rate?
A: Mortgage rates are tied mainly to the 10-year Treasury yield plus a risk premium, not the Fed funds rate, which affects short-term bank lending rates.
Q: What causes the 10-year Treasury yield to rise?
A: Strong economic data, inflation concerns, government debt issuance, and market expectations all push yields higher.
Q: Can mortgage rates come down soon?
A: They could if inflation slows, economic growth weakens, or the risk premium on mortgages narrows, but these factors depend on broader economic conditions.
Q: Is now a bad time to buy a home?
A: It depends on your financial situation and goals. While rates are higher, home prices may continue to rise, so waiting isn’t always the best choice.
Understanding the bigger picture behind mortgage rates can empower you to make better financial decisions whether you’re buying, renting, or investing. Stay informed, and good luck on your homebuying journey!
