Even if the Fed Lowers Rates, Here's Why Mortgage Rates May Not Fall as Much as You Think

According to most experts, the Federal Reserve is expected to start lowering benchmark interest rates next year. While mortgage rates will inevitably decrease as a result, the question of how much lower they'll be is quite complicated. Here's a rundown of the relationship between the Fed's interest rate moves and mortgage loans.

The Fed is expected to start lowering rates in the not-too-distant future

First, the good news. The Federal Reserve's policy-making board, the Federal Open Markets Committee (FOMC), is widely expected to start lowering interest rates after a rapid period of increases.

Even the Federal Reserve Board members themselves think interest rates are coming down. The latest projections of monetary policy by the members show a target federal funds rate of 5.6% at the end of 2023, which means that interest rates could still rise slightly from current levels. Beyond that, the members expect rates to drop a full percentage point to 4.6% by the end of 2024 and 3.4% by the end of 2025 on the way to a 2.5% rate over the long term. For context, the federal funds rate is currently set in a target range of 5%-5.25%, so this would be a significant decrease.

Investors seem to think rates could fall even faster. According to the CME Group's FedWatch tool, which monitors derivatives markets, the median expectation is a target rate of 4%-4.25% by the end of 2024.

While interest rate projections will vary considerably based on the source, one important thing to know is that virtually all experts expect benchmark interest rates to be significantly lower at the end of 2024 and 2025 than they are today.

Mortgage rates aren't directly tied to it

Mortgage rates certainly tend to move in the same direction as the federal funds rate, but it's important to know that they aren't directly tied. In other words, if the Fed raises the benchmark rate by 1%, mortgage rates don't necessarily have to move by the same amount. In fact, it's entirely possible for mortgage rates to decline when the Fed is raising rates, and vice versa.

As of this writing, there is a 1.64% gap between the 6.71% average interest rate on a new 30-year fixed-rate mortgage and the effective federal funds rate. On the other hand, at the beginning of 2022 when mortgage rates were near record lows, the difference was about 3%. Back in 2010, the difference between the average mortgage rate and the federal funds rate was about 5%.

If the current spread holds, and the federal funds rate drops to 3.4% by the end of 2025, it would result in an average mortgage rate of about 5%. On the other hand, if the spread widens to 3%, which is more in line with historical norms, the average mortgage rate wouldn't be much lower than it is today.

The bottom line

There are a lot of factors that determine mortgage rates besides the Federal Reserve's interest rate moves. Lenders' perceived risk is a big one, and supply and demand for loans is another, just to name a couple. And it's also worth noting that the historical average mortgage rate is in the 6%-7% range, and there have been times when the federal funds rate was lower than it is now and mortgage rates were even higher.

In a nutshell, if the Fed lowers interest rates, mortgage rates should follow. But there's no way to know how much they could fall.