In this short post, let’s understand why mortgage rates are not going down as fast as many Americans had hoped for, despite the Fed cutting rates. Since 2024, the Federal Reserve has cut its interest rate 6 times. 6 times! The official fed rate is down from its peak of 5.50% to 3.75%. And, yet, the mortgage rates remain stubbornly high.

Federal Funds Rate (Fed Rate) Expained

First off, what is the Fed interest rate? It is called the federal funds rate that the Federal Reserve sets eight times a year. The body that sets this rate is called the Federal Open Market Committee. FOMC consists of 12 members including the Fed chair Jerome Powell.

Think of the federal funds rate as the rate banks charge each other for very short-term loans. These loans are usually made overnight. It often happens that banks may end their day short on cash and need to borrow. Other banks have extra cash.

This interbank borrowing market is extremely important for the US economy. It affects other borrowing costs like rates on credit cards, car loans and mortgage rates. But, there is one important caveat. The Fed’s rates is an overnight interest rate. So, effectively, it is a loan with virtually zero maturity. You take this loan today only to return the principal with interest tomorrow.

Conversely, most mortgages in the US come with a fixed interest rate for 30 years. There are mortgages for 10 or 20 years. But, the 30-year mortgage is the one that most people keep an eye on.  

Intuitively, there are many more things that can happen in 10 or 20 years rather than overnight. Recessions, booms and trade wars could be in the books. So, there is more risk and more factors that can affect mortgage rates compared to the Fed’s rate. Hence, mortgage rates and the fed rate correlate, but they don’t move perfectly one for one as we see on the above graph.

10-Year Treasury Yield As A Proxy For Mortgage Rates Moves

In fact, a better proxy for mortgage rates movement is not the Fed rate. It is rather a 10-year Treasury yield. A 10-year Treasury yield is an interest rate on US federal government bonds maturing in 10 years. Both are affected by similar economic factors. Among them are economic growth, inflation and market risk.

One question that probably pops up in your mind is why use a 10- and not 30-year Treasury yield? That’s because the typical mortgage is often paid off or refinanced within 7-10 years, even for 30-year loans. Thus, the 10-year Treasury yield serves as a better proxy for long-term mortgage rates.

When you buy your home with a 30-year mortgage, banks take your loan and pool it with mortgages from other people. Based on that mortgage pool, banks create so-called mortgage-backed securities.

Think of them as something like US government Treasury bonds. Both come with fixed interest rates and maturities. The difference is that the cash flow for mortgage backed securities comes from US households. That’s unlike for Treasury debt, where the US government is the one who makes payments.

Factors That Affect The Mortgage Rate

If we look at a 30-year mortgage rate, its moves mirror those of the 10-year Treasury interest rate. We can safely add more or less 2% to the 10-year Treasury rate to get our mortgage rate.

Both tend to move up when inflation expectations rise. For instance, back in 2022, consumer prices in the US skyrocketed. As a result, lenders demanded higher returns to offset the reduction in purchasing power of future loan payments. That was the main factor behind the rise of mortgage rates back in 2022-2023.  

Also, economic cycles play a big role in mortgage rates behavior. If lenders expect an economic recession, they flock to the safety of Treasury bonds. As a result, interest rates on Treasury debt tend to fall. Usually, so does the mortgage rate.

Why Mortgage Rates Are Higher Than 10-Year Treasury Yield

But mortgage rates also don’t move in a perfect tandem with 10-year Treasury interest rates. The US government can print dollars to satisfy its debt with minimal risk of going broke. US households don’t have the luxury of the printing press. If you run out of money, bankruptcy is the next thing.

That’s why investors view US Treasury debt as a proxy for risk-free assets. Conversely, mortgages incorporate that bankruptcy risk. Hence, mortgage rates are higher than the 10-year Treasury interest rate. Here is a chart that shows the 30-year mortgage rate minus 10-year Treasury interest rate.

This is also commonly referred to as the spread between the two. Think of it as a market barometer for perception of bankruptcy risk embedded in mortgage rates. We see that the spread often spikes around economic recessions shown in gray shaded areas above.

When an economic recession hits, people lose their jobs and income. Mortgage bankruptcy rates tend to spike around those times. Thus, the difference between mortgage rates and risk-free rates on US government debt widens.

Finally, mortgage rates also reflect supply and demand in the housing and mortgage markets. But, the broad bond market still largely guides these dynamics. That’s why the 10-year Treasury yield is such a reliable indicator of where mortgage rates are going.

Mortgage Rates vs. Fed Cuts Takeaways

So, we see that the Federal Reserve does not set mortgage rates. Instead, the Fed works with the overnight interest rate. Mortgage rates are for debt with long-maturities that the market sets. So, I would not bet on major mortgage rate drops soon even if the Fed continues cutting its interest rate.

There are so many other things that move 10-year Treasury interest rates and mortgage rates. We talked about the main drivers such as inflation and economic cycles. But, there are also fiscal and monetary policies that can affect interest rates broadly speaking.

Things like inflation do not show up out of nowhere. Usually, there is a reason behind it. For instance, many investors perceive tariffs by the US government as inflationary. So far, there was no noticeable inflation spike from tariffs for one or another reason. But, if there will be one, the risk of mortgage rates staying higher for longer goes up.

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The economy is not some simple machine. There is no preset and perfect rule that says if X happens, then Y happens. It only works in theoretical economic models. There are a multitude of things happening in the economy all at once. Even seemingly minor changes can affect mortgage rates in a big way.