In December, the U.S. Federal Reserve lowered its overnight rate by 25 basis points, marking its third consecutive rate cut. But mortgage rates in the U.S. haven’t followed suit. In fact, rates have gone up – not down – since the Fed began lowering rates in September. Why? Here we look at what really affects mortgage interest rates in the U.S., and what’s behind the recent rise.
TLDR
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The 30-year mortgage rate in the U.S. is benchmarked to the 10-year Treasury yield – not the Fed’s overnight rate
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The rate on the 10-year Treasury yield is driven largely by future economic expectations rather than current monetary policy
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The U.S. is facing stubborn inflation figures and economic uncertainty as new policies take shape under a changing administration – this future uncertainty drives up the rates that are more closely tied to U.S. fixed rate mortgages
Factors that drive mortgage rates in the U.S.
The rise and fall of mortgage rates in the U.S. are not influenced by one single factor – rather, there are several drivers that may cause fluctuation. The health of the economy is a major influencer – economic downturns tend to lead to reduced demand for credit, and as lenders compete for borrowers, rates typically go down. The opposite holds true when the economy is healthy. Inflation is another key factor. Since lenders have to ensure that interest rates are higher than the rate of inflation to maintain the value of returns, mortgage rates tend to rise with inflation.
Finally, federal monetary policy decisions have both a direct and indirect effect on mortgage rates. The Federal Reserve’s overnight rate, also known as the federal funds rate, serves as a key benchmark that influences all other interest rates in the economy. But wait… the federal funds rate has been going down while mortgage rates have gone up, right? The reason is that fixed rate mortgage rates are influenced less by current monetary policy and more by future outlook.
The impact of future monetary policy and the secondary mortgage market on fixed mortgage rates
The federal funds rate is the interest rate at which banks lend money to one another overnight, making it an interest rate on very short-term lending. So, interest rates on other short-term bonds and loans will move very closely with changes to this overnight rate. Because a 30-year mortgage is a long-term loan, the correlation between the federal funds rate and the 30-year mortgage rate isn’t all that tight.
“The federal funds rate influences short-term consumer loans and credit cards,” explains Jaren Hawks, Senior Product Manager, Real Estate Financing at RBC. “A 30-year mortgage has a different timetable, so is influenced by different rates, and has a different benchmark.”
That benchmark is the 10-year Treasury yield, as its term is closer to the average mortgage. As this rate moves, mortgage rates tend to follow suit. This connection exists because of the secondary mortgage market, where investors buy mortgage-backed securities (MBS). In this secondary market, lenders bundle the mortgages they underwrite and sell them to investors. More on that later.
When it comes to the effect of monetary policy, it’s true that current monetary policy has some impact on the 10-year Treasury note rate. However, it’s investors’ expectations for future monetary and fiscal policy, economic growth and inflation that have the greater influence.
Because the Treasury yield is so closely linked to future expectations, it wasn’t the rate cut itself that had the greatest impact on fixed mortgage rates in December. Rather, it was more the message that the Fed will take a more cautious approach to rate cuts in 2025 that contributed to the rise in mortgage rates. Following the December announcement, economists changed their thinking: while they initially thought rates might be reduced to below 3 percent, they now project that the Fed will keep rates between 3.5 and 4 percent.
So, why is the Fed taking a cautious approach? At the December meeting, most Fed members agreed that inflation risks are rising, pointing to stubbornly high prices, strong economic growth, and the potential effects from changes in trade and immigration policies tabled by the Trump administration. Fed staff also warned that tariffs could slow economic growth and keep inflation high, adding to the uncertainty.
Term premiums also play a role in mortgage rates
The term premium is the portion of the 10-year Treasury yield that reflects additional compensation investors expect for buying longer-term debt versus repeatedly reinvesting in short-term securities. In other words, it’s the extra return investors demand for tying up their money in a longer-term investment, given the uncertainty and risk that comes with holding debt for a longer period. The term premium is partly driven by the balance between supply and demand for Treasury bonds and partly by uncertainty – the more uncertain the future is, the more compensation investors require because buying longer debt becomes riskier.
The 10-year term premium has risen a total of 85 basis points since September, when the Fed announced the first of last year’s three rate cuts. This rise would explain at least half of the increase in long-term rates. Case in point: the rise in the term premium aligns with the 111.7 basis-point jump in the 10-year Treasury yield during the same period.
“The spread” can have an impact on rising rates
While fixed mortgage rates and the 10-year Treasury yield are closely linked, they’re not exactly the same – there is a gap between the two, which is known to economists as “the spread.” The spread, or difference, between the rate offered on a 30-year mortgage and the 10-year Treasury note is made up of two components:
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The primary-secondary mortgage spread, which represents industry origination costs such as servicing fees, guaranty fees and other lending costs and profits
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The secondary mortgage spread, which represents the additional risk that investors take on when investing in a mortgage-backed security (MBS) relative to investing in a 10-year Treasury
Typically, the gap is 1.5 to 2 percentage points, but for much of 2023 and 2024, the gap grew to 3 percentage points, further bumping up mortgage rates.
Why have spreads been so high? Here again, uncertainty plays a role: people are unsure about the future. After all, mortgage rates soared in a short amount of time – rising from 3.15 percent in November 2021 to 7.12 percent in October 2022 – so Americans don’t really know what to think going forward! Moreover, the recent negotiations over federal debt between former President Biden and House Republicans have played a role. History has shown that even getting close to a breach of the U.S. debt ceiling could cause significant disruptions to financial markets – in fact, the last federal debt showdown – in 2011 – caused spreads to widen.
With this potential economic disruption comes a wariness by both lenders and investors to take on risk, which in turn translates to an extra fee to borrow. As such, spreads rise.
Another contributing factor is that there are fewer buyers for mortgage mortgage-backed securities (MBS). During the pandemic, the Federal Reserve bought billions of dollars’ worth of mortgage bonds, but they’re no longer in the market for them. And so, remaining MBS buyers are looking for a better deal. As you might expect, when investor demand is high, mortgage rates trend lower. When investors aren’t buying, rates might rise to attract them.
While spreads have leveled out recently, their sustained widening in recent years have contributed to the rise in mortgage rates.
How the Fed rate cuts affect adjustable-rate mortgages
Fixed-rate mortgages dominate the U.S. mortgage landscape – of the 40 percent of Americans that have a mortgage, a whopping 92 percent have a fixed rate mortgage. The remaining 8 percent have adjustable-rate mortgages (ARMs). Adjustable-rate mortgages (also known as variable-rate mortgages) have interest rates that can change over time based on the financial index they are linked to. While they start out with a fixed rate for a certain period of time, once this fixed period is up, rates adjust on a regular basis according to whatever index the rate is tied to.
For example, with a 7/1 ARM, you would pay the same interest rate for the first seven years, then the rate would adjust every year after that. With a 5/6 ARM, meanwhile, the rate is fixed for the first five years, then adjusts every six months.
The rates on ARMs are often tied to the Secured Overnight Financing Rate (SOFR). Because the Fed’s rate decisions influence savings tools, raising or lowering the federal funds rate can make the SOFR go up or down. Accordingly, ARM rates go up or down as well when the rate resets.
So, if the federal funds rate goes up, your ARM rate will increase as well at the next adjustment. And of course, when the federal funds rate goes down, so too will your ARM rate.
“While ARMs can help you save money in a declining interest rate environment, the risk of rising rates is a key reason so many Americans prefer the stability of a fixed-rate mortgage,” says Hawks.
How Canadian and U.S. mortgages respond differently to federal rate cuts
If you have both a Canadian and U.S. mortgage and have seen federal interest rate cuts both sides of the border, you may wonder why Canadian mortgage rates have come down while U.S. mortgage rates have gone up. The main reason is that Canadian mortgages have shorter refinancing terms versus their U.S. counterparts. Consider this: In the U.S., the mortgage terms span the length of the amortization period – hence the 30-year fixed rate mortgage. Canadian mortgages, meanwhile, have a number of shorter mortgage terms within the amortization period (think your standard 3-year or 5-year term). This means that changes to the Bank of Canada’s overnight rate affect Canadians’ mortgage rates more directly.
More Canadians have variable rate mortgages than Americans too – while roughly 13% of Canadians had variable rate mortgages at the start of 2024, their popularity is rising once again. Remember, only 8 percent of Americans have a mortgage with a variable rate.
Bottom line
The U.S. Federal Reserve doesn’t determine fixed mortgage rates, but its policy decisions do affect the larger economic picture, which in turn influences your borrowing costs. So, while interest rate cuts may not have a direct impact, the Fed’s monetary policy will affect mortgage rates indirectly – it’s just not an immediate correlation. Rather, a complex web of factors influence fixed mortgage rates. And, with considerable uncertainty, sticky inflation figures and changing policies with a new U.S. President, the Fed has issued a message of caution. This means mortgage rates haven’t dipped even with recent rate cuts – and they will likely maintain their current range for the foreseeable future.
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