Why Federal Reserve Rate Cuts Don’t Directly Lower Mortgage Rates

When the Federal Reserve announces a cut in interest rates, many people immediately assume that mortgage rates will drop as well. Unfortunately, this is a common misconception. When the Fed adjusts its rates—specifically the Federal Funds Rate—it doesn’t directly impact long-term mortgage rates. Instead, these cuts are aimed at influencing overall economic conditions, particularly inflation and corporate borrowing costs.

So, what happens when the Fed cuts interest rates, and why don’t mortgage rates immediately follow? Let’s break this down.

Understanding the Federal Funds Rate

The Federal Reserve uses the Fed Funds Rate to influence economic activity by making borrowing either more expensive or cheaper for financial institutions. This rate is essentially the interest rate at which banks lend to one another overnight. It’s a tool the Fed uses to slow down or stimulate economic growth, depending on the current state of the economy.

For example, if inflation is rising too fast, the Fed may increase rates to curb borrowing and spending, slowing down inflation. When inflation is under control, as it is right now, the Fed might cut rates to encourage borrowing and economic growth. In September 2024, the Fed cut interest rates by 50 basis points (or 0.50%) to 4.8%—a move designed to signal that inflation is no longer a major threat.

Mortgage Rates Don’t Drop Automatically

Many consumers believe that when the Fed cuts interest rates, mortgage rates will immediately decrease. This is not the case. Mortgage rates are tied more closely to the bond market—specifically, the yields on 10-year Treasury notes—than to the Fed Funds Rate.

Before the Fed’s recent cut, mortgage rates had already factored in the anticipation that the Fed would lower interest rates by 25 or 50 basis points. In other words, the market had already “baked in” the likelihood of this rate cut into mortgage rates. So, when the Fed made its move, mortgage rates didn’t get significantly better because the bond market had already priced in the expectation.

Mortgage rates fluctuate based on the demand for mortgage-backed securities (MBS). When the bond market is performing well, investors flock to safer, long-term assets like MBS, which often leads to lower mortgage rates. Conversely, when the stock market is booming—as it did following the Fed’s rate cut—investors pull money out of bonds to chase higher returns in stocks. This leads to higher yields in the bond market, pushing mortgage rates up.

Inflation and Mortgage Rates

Inflation is the primary enemy of both the bond and stock markets. When inflation is high, the value of long-term bonds decreases because the returns on these bonds are eroded by inflation. This drives bond yields higher, which in turn drives mortgage rates up.

When the Federal Reserve cuts interest rates, they are signaling that inflation is under control. Over time, this can positively impact mortgage rates, but the change is not immediate. The bond market still needs time to stabilize, and other economic factors come into play before we see any significant movement in mortgage rates.

The Impact of Economic Health on Mortgage Rates

The overall health of the economy is a much bigger driver of mortgage rates than the Fed’s interest rate decisions. Economic data—such as rising unemployment, slow job growth, or companies downsizing—can lead to lower mortgage rates. When the economy weakens, the bond market becomes a safe haven for investors, driving bond yields down and improving mortgage rates.

For example, if the economy heads into a recession, it’s likely that mortgage rates will decrease. A recession would increase demand for bonds, lowering bond yields and consequently mortgage rates. So while the Fed cutting rates signals that inflation is in check, other economic factors, such as a potential recession, might lead to a more significant drop in mortgage rates over time.

Don’t Try to Time Mortgage Rates—Focus on Your Financial Situation

Many homebuyers make the mistake of trying to time the market, hoping for a better mortgage rate. This strategy is risky because mortgage rates are influenced by a wide array of unpredictable factors, including inflation, the bond market, and broader economic conditions.

If you’re waiting for rates to drop another 0.125% or 0.25%, you might miss out on locking in a rate that’s already beneficial to your financial situation. If you can refinance and save several hundred dollars per month at the current rate, chasing an extra $30 or $40 in monthly savings by waiting is not worth the risk. In other words, don’t pass up dollars to save dimes.

When Should You Refinance?

If your current mortgage rate is 6.375% or higher, now is a good time to consider refinancing, especially if rates have come down a bit. Locking in a lower rate can help you save hundreds of dollars on your monthly mortgage payments. Waiting for an additional 0.125% or 0.25% drop in rates is like trying to time the stock market—it’s highly speculative and could cost you more in the long run.

Conclusion: What to Watch For

The Fed’s recent rate cut is a sign that inflation is under control, and while this doesn’t directly lower mortgage rates, it does set the stage for potential improvements in rates over time. However, it’s important to keep in mind that economic health, bond market fluctuations, and investor behavior have a more immediate impact on mortgage rates.

So, if you’re in the market for a home or considering refinancing, focus on your budget, income, and savings rather than waiting for rates to drop further. Waiting for the perfect rate might mean missing out on savings that are already available today.

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