How Are Mortgage Rates Determined?

Learn whether Fed interest rate cuts can lower your mortgage payments

Real estate values chart
••• Getty Images/Olena_T

There are two common misconceptions by people in the financial media, real estate and lending professions, including those from the public. It’s one thing for the laymen to get it wrong; it’s another thing entirely when a financial professional gets it wrong.

The first is how mortgage rates are determined, followed by the effect on mortgage rates by the U.S. Federal Reserve Bank.

What are mortgage rates based on?

The only correct answer is mortgage bonds or mortgage-backed securities. Mortgage rates are not based on the 10-year Treasury Note. When shopping for a new home loan, many of you will jump online to your favorite financial website to see how the 10-year Treasury Bill is doing. In reality, mortgage-backed securities (MBS), cause mortgage rates to fluctuate. In fact, it is not unusual to see them move in completely different directions and, without professional guidance, that confusing movement could cause you to make make a poor financial decision.

Many bond market reporters mistakenly tie mortgage rates to the performance of the 10-year T-Bill. Many of these financial reporters possess a broad knowledge of bond markets, but they are not mortgage experts and do not fully comprehend how mortgage interest rates are determined.

My suggestion is to avoid working with lending professionals who keep their eyes on the wrong indicators.

The Fed lowered rates -- Why aren't mortgage rates going down?

When the Fed lowers the short-term discount rate, this is designed to stimulate consumer spending on short-term credit, which affects credit card rates, some car loans and lines of credit. The short-term discount rate has little effect on long-term mortgage rates.

Think about this: the market moves faster than you may expect -- sometimes at lightning speeds. When investors spot a short-term stimulus, they bail out of the safe haven of bonds -- or mortgage-backed securities -- and move those dollars into stocks. When this happens, we see a rally in the stock market and a sell-off of mortgage-backed securities, both of which cause interest rates to go up.

We have all heard the radio commercials from lenders: “The Fed is at is again -- slashing rates. Don’t miss this opportunity to get the lowest rates in years! Call us today, before it’s too late!” We even hear it on the nightly news: “Fed set to cut rates again. This action will help to stimulate the housing market”.

They aren’t necessarily lying to us, but they are being disingenuous by implying that mortgage rates are going to follow suit and fall. Don’t fall for the hype. It’s a ploy. They figure if they say something is true long enough, people will start believing it. It makes the phone ring, and that’s all that matters to many of these lenders, some of whom, I may add, are teetering on extinction.

The Reality of Fed Rate Cuts

When the Fed cuts the rates, especially by a large or repeated percentage-point drop, people automatically assume that mortgage rates will fall. But if you follow mortgage rates, like I do, you will see that most of the time, the rates fall very slowly, if at all. Historically, when the Feds have dramatically cut rates, interest rates remain almost identical to the rates established months before the cut as they do months after the cut.

The Fed’s moves aren’t totally irrelevant and do have a delayed and indirect impact on home loan rates. When investors worry about inflation, this concern will push rates up. When Congress wants to stimulate action and raise money for a deficit, it will create more U.S. Treasuries for folks to buy. This added supply of new Treasuries can also cause rates to move higher.

I caution my clients to avoid the siren and the false sense of security it creates by thinking mortgage loan rates are going to improve just because the Fed cut rates.

Even more crucial is when a buyer is in the process of making a decision whether to lock a loan just before a Fed rate cut. Say a buyer is in a contract and thinking the Fed is going to lower rates next week. The buyer might be tempted to wait before locking the loan -- big mistake. When the Fed makes that big drop, say by 50 basis points or more, it actually can cause 30-year-fixed rates to initially spike. But then over time the rates generally level out or regain their losses -- depending, of course, upon current market trends.

So, if my buyer is within three weeks of closing before an anticipated Fed cut, I usually recommend locking ahead of the Fed rate cut to protect that original good interest rate.

Dan Tharp works at Comstock Mortgage in Sacramento, CA.

At the time of writing, Elizabeth Weintraub, BRE # 00697006, is a Broker-Associate at Lyon Real Estate in Sacramento, California.