Why borrowing costs are falling, but mortgage rates aren’t

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Even as borrowing costs ease for credit cards, auto loans and home equity lines of credit, mortgage rates remain stubbornly high.

The Federal Reserve lowered its benchmark rate last week for the first time this year, and mortgage costs briefly dipped in anticipation. But the reprieve didn’t last — 30-year fixed rates are climbing again, back to about 6.37%, as of Thursday. They’ve been stuck above 6% for the past three years.

So, what gives?

While the Fed’s rate influences what you pay on credit cards, personal loans and auto financing, it isn’t much of a driver behind mortgage rates.

How mortgage rates really work

Fixed mortgage rates — unlike variable mortgages that move more with Fed rate changes — are most closely tied to 10-year Treasury bonds.

When a bank issues a mortgage, it usually bundles the loan with other mortgages and sells it to investors as a bond. The interest homeowners pay on their mortgages becomes a stream of payments to those bondholders. The return on those bonds is called the yield, expressed as a percentage of the price buyers paid.

To decide what return mortgage bond investors will accept, lenders look to the 10-year Treasury — a government bond that also pays interest and is seen as the best comparison, since most homeowners move or refinance after about a decade.

Mortgage rates usually end up one to two points higher than the 10-year yield to cover risks that Treasuries don’t face — like homeowners defaulting, borrowers refinancing early if rates fall or the fact that mortgage bonds are harder to trade than government securities.

Right now, that gap — known as the spread — is wider than historical norms, well above 2%. It’s a big reason mortgage rates remain elevated above 6%.

Why the spread is so wide

The spread has been wider than normal for two main reasons, Selma Hepp, chief economist at Cotality, tells CNBC Make It.

Inflation “remains sticky,” especially for services and shelter, she says, with overall inflation climbing back to 2.9% year over year in August — above the Fed’s 2% target. Since higher inflation erodes the value of mortgage bond payments, investors tend to seek higher yields.

And the Fed’s pullback from buying mortgage-backed securities has left private investors to fill the gap. “With less demand, [mortgage-backed security] prices fall, yields rise and mortgage rates increase. This widens the spread relative to Treasuries,” says Hepp.

Considering that the Fed’s own projections don’t have inflation reaching 2% until 2028, the “current dynamic is likely to continue,” says Christopher Hodge, chief economist for the U.S. at Natixis CIB Americas. “This has increased longer-term inflation expectations, which increases the premium demanded for mortgages.”

Those expectations help explain why Fannie Mae projects 30-year fixed rates will stay above 6% for another year, according to an updated forecast released Tuesday.

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