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After skyrocketing during and after the pandemic, mortgage rates are down more than 1% from their October 2023 peak. But what’s behind this shift, why did rates soar in the first place and how much further can hopeful buyers expect mortgage rates to drop in 2024?
The Federal Reserve’s aggressive interest rate hikes to rein in runaway inflation were one major cause for the increase. Although mortgage rates aren’t directly tied to the Fed’s benchmark federal funds rate (the short-term rate banks use when lending to each other overnight), the increases had ripple effects that played a significant role in rising home loan rates.
In addition to this, two other factors—highlighted in a recent Brookings Institution report—also contributed to the spike in mortgage rates, kept them overly elevated and influenced their recent decline.
Why Mortgage Rates Surged in 2022 and 2023
While the federal funds rate only indirectly impacts mortgage rates, the 30-year-fixed mortgage rate is somewhat benchmarked by the 10-year Treasury bond yield, with the 30-year fixed-rate mortgage typically higher than the 10-year Treasury yield.
The difference between the two is known as the mortgage spread.
How the Mortgage Spread Kept Rates Elevated
The spread between the 10-year Treasury yield and 30-year-fixed mortgage rate reflects the risk that investors take on with mortgage-backed securities. Mortgage-backed securities, or MBS, are investments backed by pools of mortgages.
Historically, this spread has hovered between 150 and 200 basis points. (A basis point is equal to one-hundredth of a percentage point.)
“The average mortgage spread in 2021 was 1.5% and nearly doubled to 2.9% in 2023,” Melissa Cohn, regional vice president at William Raveis Mortgage, tells Forbes Advisor. “This sharp increase was a result of a number of factors, including monetary policy. The Fed raised rates to fight inflation, which in turn caused bond yields to rise, reduced demand, increased prepayment risk due to high rates, and [reduced] competition as banks pulled away from the mortgage business.”
Prepayment risk occurs when homeowners sell or refinance sooner than anticipated, adding uncertainty for MBS investors.
The Impact of the Inverted Yield Curve on the Mortgage Spread
Additionally, Brookings’ analysis revealed that the 10-year Treasury yield falling below shorter-term bond yields contributed to the widening mortgage spread. This created a rare so-called inverted yield curve, where short-term Treasury bonds offered higher returns than longer-term bonds.
Experts attribute this inversion to the rapid rise in the federal funds rate, as the Fed’s short-term interest rate is closely linked to shorter-term bond yields.
According to the Brookings report, these combined forces helped push the mortgage spread to its highest levels since the 2008 housing crisis.
What Drove the Mortgage Rate Drop and What’s Next For Rates?
The good news is that the aforementioned factors that helped drive mortgage rates higher were temporary. According to Brookings, these conditions are starting to unwind, leading to a narrowing of the mortgage spread and the easing of mortgage rates.
Notably, the inverted yield curve has righted itself, with longer-term Treasury yields again exceeding shorter-term yields. Prepayment risks have also decreased amid more certainty around the future of interest rates.
Moreover, weaknesses in the economy—namely in the labor market—led to anticipation of the September Fed rate cut. This helped push mortgage rates down in August, according to Cohn.
“Mortgage spreads also declined to 2.1%,” she says.
How Much Will Mortgage Rates Fall and the Spread Narrow?
While the Fed has signaled additional rate cuts are in store—barring any unforeseen shocks—many housing experts believe these subsequent cuts are already factored in. This makes significant mortgage rate drops unlikely before 2024 ends.
Nonetheless, Cohn says the mortgage spread should narrow—but it will take some time.
“The spread should continue to drop toward the 1.5% historical average when bond yields continue to fall,” she says. “That may not happen until next year as there is a lot of volatility in the market now and a lot of external factors, such as the election and geopolitical events.”
Should You Buy a Home Now or Wait Until 2025 For Lower Mortgage Rates?
Despite the insights that data and economic trends provide, predicting where mortgage rates are headed and timing their ups and downs to land the lowest rate is often a losing gamble.
“You can’t just sit around and wait for rates to drop,” Cohn says, advising that it’s better to “find a house you want to buy and then worry about rates secondly.”
In the meantime, experts recommend hopeful home buyers take these key steps to ensure they snag the best rate when they’re ready to commit to a mortgage:
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