How the Federal Reserve affects mortgage rates

What does the Federal Reserve do?

The Federal Reserve acts as the central bank of the U.S., although it operates separately from government entities. While not technically "owned" by anyone, the Federal Reserve gained its authority through Congress, which created the Federal Reserve System in 1913.

According to the Board of Governors of the Federal Reserve System, the organization takes on a variety of roles to promote the public interest. These roles include five main functions:

1. Setting monetary policy. The Federal Reserve oversees the nation's monetary policy in order to create optimal economic conditions such as high employment rates and low inflation levels. The Fed does this in part by moderating long-term interest rates through the federal funds rate.
2. Promotes stability. The Fed aims to "contain systemic risks" and promote the overall stability of our financial system.
3. Promotes safety. Federal Reserve policies aim to promote "safety and soundness" among U.S. financial institutions.
4. Manages U.S. dollar payments and settlements. The Fed monitors a range of payment and settlement systems for transactions made with the U.S. dollar.
5. Provides consumer protections. The Fed takes steps to protect American customer interests through research, analysis, economic development activities and more.

What is the federal funds rate?

The first function of the Fed we listed — setting monetary policy — is largely done through the federal funds rate. The federal funds rate is an interest rate set by the Fed and used by banks and other financial institutions when they lend money to one another.

Financial planner Nick Holeman of Betterment explained that every bank has a cash reserve requirement to ensure they can cover customer withdrawals, and whatever is left over can be loaned to each other. Holeman says that each time the federal funds rate moves up or down, it influences interest rates for loans, credit cards, savings accounts and a range of other financial products.

This makes the federal funds rate a sort of "tide that lifts all boats," said wealth advisor Kirill Semenov of financial firm Intellicapital Advisors.

"If it costs more for the bank to get funds, it will demand a higher reward for lending the money out,” he explained. “An easy way to think of the federal funds rate is to consider it the cost of doing business for the banking sector."

» MORE: How the Federal Reserve impacts savings account rates

The federal funds rate and mortgages

The federal funds rate impacts fixed-rate mortgages for new customers and adjustable-rate mortgages (ARMs) for both new and existing customers.

• With fixed-rate mortgages, you’re locked into the current rate at the time of signing. So, if you’re buying a house and the federal funds rate is high, it’s likely the rate on your mortgage is high. However, if you already have a fixed-rate mortgage, you won’t be affected by changes to the federal funds rate since your rate is already set.
• ARMs are based on the Secured Overnight Financing Rate (SOFR), which is also influenced by the federal funds rate. When the Fed increases the federal funds rate, homeowners with an ARM can see their mortgage rate increase, and their monthly mortgage payment right along with it.

However, the current mortgage rates are also impacted by additional economic factors like the buying and selling of government securities. For example, mortgage rates were still dropping at the end of March 2023 due to the downward trend of 10-year Treasury yields, despite Fed rate increases.

Federal funds rate and home equity products

Home equity lines of credit (HELOCs) are almost always variable-rate loans with rates tied directly to the prime rate. This means rates change for HELOCs every time the Fed increases the federal funds rate, explained Holeman. "If rates go up, a HELOC will get more expensive within one to two billing cycles."

With that in mind, Holeman says HELOCs typically make the most sense for people who need funds they can use incrementally with shorter expected payback periods. For example, to cover home improvements or debt consolidation.

For home equity loans, it is typically only new customers who are impacted by an increase in the federal funds rate. Since home equity loans come with fixed interest rates, they stay the same for the duration of the loan. That means home equity loan customers won't see their rate change in the middle of repayment like they would with a HELOC.

Other factors that influence mortgage rates

Not all factors impacting mortgage rates are economic in nature. Rates also depend on a homebuyer's financial situation.

For example, your credit score can impact the mortgage rates you can qualify for, or even if you're able to get a mortgage at all. Most conventional home loans require a minimum credit score of 620, whereas you may be able to get approved for certain government-backed mortgages with a lower score.

Additional factors that influence mortgage rates include the down payment amount, how much other debt you have (known as your debt-to-income ratio, or DTI), the home’s location and the loan type.

The purpose of the property will also impact mortgage rates. For example, homebuyers usually qualify for lower interest rates for a primary residence than they can for investment properties or second homes.

You also may be able to lock in a lower interest rate if you’re willing to pay "points," which are a form of prepaid interest on a mortgage. A mortgage point typically equals 1% of the loan amount, and each point leads to a mortgage interest rate deduction of 0.25%.

Finally, Holeman says loan level price adjustment (LLPA) formulas are yet another factor that can impact mortgage rates.

"These formulas dictate rules lenders must follow, and adjust the interest rates based on factors such as credit score, down payment size, the type of property and more," he said.

» MORE: What credit score is needed to buy a house?

How to shop for mortgage rates

Securing a lower mortgage rate can lead to tens of thousands of dollars in interest savings over the life of a loan.

For example, a 30-year fixed-rate home loan for $350,000 at 6.5% would require a monthly payment of $2,212.24 (including principal and interest) and total interest charges of $446,405.71 over three decades.

However, the same loan with an interest rate of 6% would require a monthly payment of $2,098.43, and total interest charges of $405,433.66.

That's a difference of $40,972.05 for a rate difference of just 0.5%.

The following tips could help you get a lower mortgage rate:

• Consider more than one loan type. Different types of home loans can offer different rates, so you may want to consider more than the standard 30-year, fixed-rate mortgage. For example, loans with shorter durations can come with lower interest rates, and ARMs start out with a lower teaser rate that stays fixed for a certain period of time but eventually resets based on market rates.
• Compare rates and terms across multiple lenders. Different lenders may be able to offer lower mortgage rates. Before you move forward with a loan application, find out where rates fall with at least three other lenders.
• Get pre-qualified online. Some mortgage lenders may let you "check your rate" or get pre-qualified online without a hard inquiry on your credit reports. While this doesn't mean you're guaranteed to be approved for a mortgage, the process does let you see what your rate could be without any credit score impact.

Bottom line

Plenty of factors help determine where mortgage rates fall at any given time, and this includes moves made by the Federal Reserve to influence monetary policy. However, there are still areas where you have some control over the mortgage rates you qualify for, including your credit score, your down payment and the type of mortgage you apply for.