What Happens to My Mortgage Rate If the Fed Raises Interest Rates?

(Spoiler: It’s Not What You Think)

When the Federal Reserve announces a rate hike, the headlines scream: "Fed Raises Rates! Borrowing Costs to Soar!"

Naturally, if you are shopping for a home, you might panic. You might assume that if the Fed raises rates by 0.50%, your mortgage quote will instantly jump by 0.50%.

But that is not how it works.

While the Fed has a massive influence on the economy, they do not set mortgage rates. In fact, there are times when the Fed raises rates, and mortgage rates actually go down.

Here is the truth about the relationship between the Fed and your 30-year fixed mortgage.

The Fed Controls the "Short Game," Not the "Long Game"

To understand why your mortgage rate doesn't move in lockstep with the Fed, you have to understand what the Fed is actually changing.

When the Federal Reserve raises the Federal Funds Rate, they are increasing the cost for banks to borrow money from each other overnight. This directly impacts short-term debt, such as:

• Credit Card APRs
• Home Equity Lines of Credit (HELOCs)
• Auto Loans

These are short-term liabilities. However, a 30-year fixed mortgage is a long-term liability. The bank is lending you money for three decades. Therefore, the price of that loan isn't based on what happens overnight; it's based on what investors think will happen over the next 10 to 30 years.

The Real Boss: The 10-Year Treasury Yield

If the Fed doesn't set mortgage rates, who does?

Mortgage rates generally track the yield on the 10-Year US Treasury Note.

Think of the 10-Year Treasury as the "safe bet." If an investor can get a guaranteed 4% return from the US government (by buying a Treasury bond), they aren't going to lend money to you for a house at 4%. They need a "risk premium" to make it worth their while.

So, mortgage rates usually sit about 1.5% to 3% higher than the 10-Year Treasury yield.

• If the 10-Year Treasury goes up, mortgage rates go up.
• If the 10-Year Treasury goes down, mortgage rates go down.

So, How Does the Fed Affect the Treasury? (The Indirect Link)

This is where it gets tricky. The Fed raises rates to fight inflation.

• Inflation is the enemy of bonds. If inflation is high, the money an investor gets back in 10 years will be worth less. So, when inflation is high, investors demand higher yields (interest rates) to protect themselves. This drives mortgage rates UP.
• The Fed raises rates to cool the economy. By making borrowing expensive (credit cards, business loans), the Fed hopes to slow down spending and kill inflation.

Here is the paradox: If the Fed raises rates aggressively, investors might think, "Okay, the Fed is serious. They are going to slow the economy down and crush inflation."

If investors believe inflation will drop in the future, they feel safer buying long-term bonds. This causes the 10-Year Treasury yield to drop.

Result: The Fed raises the short-term rate, but the long-term mortgage rate might actually fall because the market believes inflation is being tamed.

The "Recession" Factor

There is one other scenario where Fed hikes lead to lower mortgage rates: Fear of a Recession.

If the Fed raises rates too high, too fast, they might break the economy and cause a recession.

• When a recession hits, the stock market usually crashes.
• Investors flee the stock market and run to the safety of bonds (Treasuries).
• High demand for bonds drives yields down.
• Mortgage rates drop.

So, ironically, bad economic news is often "good" news for mortgage rates.

The Bottom Line for Borrowers

If you are watching the news and see "Fed Hikes Rates," don't assume your home purchase is doomed.

1. Watch the 10-Year Treasury, not the Fed. If that number is climbing, your rate is climbing.
2. Watch Inflation Reports (CPI). This is the real driver. If inflation reports come in "hot" (higher than expected), mortgage rates will spike. If inflation cools down, rates will likely drift lower.
3. Don't try to time the market. The relationship between the Fed, inflation, and bonds is complex and volatile. If the monthly payment fits your budget today, lock it in. You can always refinance later if the Fed's war on inflation eventually drives rates down.