Why Mortgage Rates Track The Ten Year Treasury, Not The Fed

The morning the news said the Fed had cut rates, I texted a lender I had been talking to and asked what it did to my quote. He sent back a number higher than the one he had given me the week before.

I assumed he had made a mistake. He had not. I was watching the wrong rate.

Two rates with the same nickname

When a headline says the Fed cut rates, it means the federal funds rate, the interest banks charge each other to borrow overnight. Overnight. That rate moves the cost of short borrowing almost immediately: credit card APRs, the annual percentage rate on your card, home equity lines, and what a savings account pays you.

A thirty year fixed mortgage is a different animal. The lender is agreeing to a single rate for up to 360 months, and nothing about an overnight rate tells them what money will cost across that stretch.

So they look at a longer loan instead. Specifically, the ten year Treasury yield, which is the annual return the US government pays to borrow for ten years.

Why ten years and not thirty

Because almost nobody keeps a thirty year mortgage for thirty years. People sell the house, move for a job, refinance when rates drop, or pay the loan off with an inheritance. Most mortgages end, one way or another, inside roughly a decade.

Lenders rarely keep the loans either. Most get bundled into mortgage-backed securities, bonds whose payments come from thousands of homeowners' monthly checks, and sold to investors. Those investors are holding something that behaves like a loan of around ten years, so they compare it with the safest loan of around ten years, the Treasury.

Then they ask for more. That extra is the spread.

The spread, in dollars

The spread is the average thirty year fixed mortgage rate minus the ten year Treasury yield. Over the long run it has averaged roughly 1.7 percentage points. In some recent years it has been wider, around 2.5 to 3 points.

A percentage point sounds small until you put a loan under it. Take an illustrative ten year yield of 4 per cent and a 2 point spread, so a 6 per cent mortgage on $400,000.

The first month's interest is $400,000 times 0.06 divided by 12, which is $2,000. Of that, $400,000 times 0.04 divided by 12, or $1,333.33, is the Treasury part. The other $666.67 is the spread.

A third of the interest you pay in month one has nothing to do with the government's borrowing cost.

The ten year yield is the same 4 per cent in every row. The only thing changing is the spread, and it moves the payment from $2,321.60 to $2,661.21. That is $339.61 a month, or $122,259.60 across 360 payments, for the identical house and the identical Treasury yield.

Half a point, worked through

The payment uses the standard amortisation formula: loan times monthly rate, divided by one minus (1 plus the monthly rate) raised to the power of minus 360. At 6 per cent the monthly rate is 0.06 divided by 12, which is 0.005, and $400,000 comes out at $2,398.20 a month.

At 6.5 per cent the monthly rate is 0.065 divided by 12, about 0.0054167, and the payment is $2,528.27.

The difference is $2,528.27 minus $2,398.20, which is $130.07 a month. Times 12 that is $1,560.84 a year. Times 360 it is $46,825.20 over the life of the loan.

Half a point of spread. $46,825.20.

Why the spread gets wider

Three things push it out, and none of them is the Fed's overnight rate.

• Prepayment risk. When rates fall, homeowners refinance and hand the investor their money back at exactly the moment it can only be reinvested at lower rates. Investors charge for that in advance.
• Rate volatility. When nobody is sure where yields will be next quarter, the chance of that early payoff becomes harder to price, and anything harder to price costs more.
• Lender margins. Originating and servicing a loan costs money, and when lenders are flooded with applications or nervous about their own funding, they keep more of the rate for themselves.

Any one of those can add a quarter or half a point on its own. On $400,000, half a point is the $130.07 a month above.

Why a Fed cut does not automatically lower your rate

The ten year yield is roughly what investors expect short rates to average over the next ten years, plus something for inflation and for tying money up that long. A cut the market saw coming is already sitting inside that yield, often for months before the announcement.

And if investors read a cut as a sign inflation will run hotter, they can demand more to lend for ten years, which pushes the yield up. That is how the Fed cut in late 2024 and the average thirty year mortgage rate climbed over the following months. My lender's text was not a mistake. It was the ten year.

So the Fed matters, but indirectly, through what it does to expectations about the next decade. The overnight rate itself never appears on your Loan Estimate.

Build your own rough range

Open the US10Y line on the Rates board, or the related quotes beside this article. Add 1.7 to it for the low end of a rough expectation and 3 for the high end. With an illustrative 4 per cent yield, that is 5.7 to 7 per cent.

Then price the two ends on your own loan amount, the same way as the table, so the range is in dollars a month and not in per cent. On $400,000 the illustrative range is $2,321.60 to $2,661.21.

Your actual quote will depend on your credit score, your deposit, the points you buy and the day you lock, so it will not land exactly on either end. What the range gives you is a question to ask. If a quote comes in above the top of it, ask the lender which part of your file put it there, and get a second Loan Estimate the same day before you sign anything.