If you follow news about the economy, you’ll hear a lot of talk about the Federal Reserve (a.k.a. the Fed) and its influence on borrowing costs. This is especially true if you are in the market for a new home or are thinking about refinancing. And while the Fed doesn’t directly set mortgage rates, its decisions have a major impact on interest rates for home loans. But how exactly does that happen and what does it mean for you? Here’s a mini-lesson on how those rate changes could alter your home borrowing experience.
Why Does the Fed Change Rates?
The Federal Reserve controls the federal funds rate—the interest rate banks charge each other for short-term loans. This rate helps regulate the economy by influencing borrowing, spending, and inflation. The Fed typically meets eight times a year to decide whether to raise, lower, or keep interest rates the same. Their goal is to maintain a healthy economic environment by adjusting rates to either stimulate growth or cool down inflation when it becomes excessive.
- When inflation is high, the Fed raises rates to slow borrowing and spending.
- When the economy is weak, the Fed lowers rates to encourage borrowing and boost economic activity.
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How Mortgage Rates Are Affected
While mortgage rates aren’t set by the Fed, they often move in the same direction as the federal funds rate. Here’s how the chain reaction works:
1. Banks Adjust Their Interest Rates.
When the Fed raises or lowers its rate, banks adjust the rates they charge on loans, including mortgages. A higher Fed rate makes borrowing more expensive. A lower rate makes it cheaper.
2. Mortgage Rates Follow Suit—But Not Instantly
Mortgage rates don’t move exactly in step with the Fed rate, but they generally trend in the same direction. Lenders consider many factors, including inflation, investor demand, and the broader economy when setting mortgage rates.
3. Fixed vs. Adjustable Mortgage rates
- Fixed-Rate Mortgages: If you already have a fixed-rate mortgage, changes in the Fed rate won’t affect your interest rate. However, if you’re applying for a new mortgage, a higher Fed rate could mean higher borrowing costs.
- Adjustable-Rate Mortgages (ARMs): If you have an ARM, your interest rate is likely tied to a financial index that moves with the Fed rate, meaning your monthly payments could increase or decrease over time.
Other Factors That Influence Mortgage Rates
While the Fed rate is important, mortgage rates also depend on:
- The bond market. Mortgage rates are closely tied to the yield on 10-year Treasury bonds. When bond yields rise, mortgage rates usually go up, and vice versa.
- The housing market. High demand for homes can lead to higher mortgage rates. So can rising construction costs caused by inflation, labor shortages, and supply chain issues. If construction costs are high, builders may build fewer homes, which stresses the demand for existing homes.
- The economy. If the economy is strong, demand for homes increases, pushing rates higher. If there’s uncertainty or a recession, rates may drop.
- Your financial health. Even if national rates go down, lenders look at your credit score, income, and debt to set your individual mortgage rate.
Why It Matters for You
Understanding how the Fed rate impacts mortgage rates can help you make better financial decisions. So, if you’re thinking about buying a home or refinancing in 2025 or 2026, pay attention to Fed announcements. Their decisions ripple through the economy and make a huge difference for banks and borrowers alike. A rate hike might mean higher costs for the average consumer, while a rate cut could lead to savings.
Hopeful home buyers can’t, of course, control the Fed’s decisions, but they can manage their credit scores and debt levels while they watch the story play out. They can create a financial plan to get the best mortgage rate possible in the current market.
If you are hoping to purchase a home or refinance one, keep an eye on interest rate trends and take a thoughtful approach. Staying informed can not only help you navigate the housing market and make smart choices but also save you a whole lot of cash.
Want more home buying tips?
- Check out our mortgage glossary for all the terms you’ll need to know when buying your dream house.
- Find out what a HELOC is (and how to use one).
- Learn the basic steps you should take before selling your home.