How long will it take for mortgage rates to reach “Normal”?

For the second straight week mortgage rates have fallen as Freddie Mac is reporting a quarter point (.25%) reduction since record highs at 7.79% on October 26^th. This slight reduction may not feel like much to the consumer today, but it’s a sharp contrast to the increasing rates over the last 2 years. In fact, the recent drop since the FOMC’s last meeting is the sharpest that rates have fallen within the last year.

The recent decline in mortgage rates comes after the FOMC’s announcement in early November to stay the federal funds rate. Also, recent inflation data released today showing lower than expected inflation numbers prompting an overall positive outlook to the economy. During the FOMC’s last announcement the FED Chair specifically spoke regarding the fact that the economy has yet to fully feel the effects of their rate adjustments and that time was needed for adaptation. It appears that now inflation data is showing the effects are being realized which is helping to relieve the pressure of increasing rates. 

When it comes to mortgage rates, banks and credit unions sell mortgages at rates higher than the Federal Funds rate to create profit and provide a yield to their investors and bottom line. When the Federal Funds Rate is 5%, the average mortgage rate in theory will be approximately 7% - 7.25% based on credit and a buyer’s debt to income. But, mortgage companies don’t know what the Federal Funds Rate will be in 30-45 days when they close the mortgage. So, they must watch inflation data and anticipate if the Federal Funds Rate will go down or up within the next 30-45 days when the mortgage closes. When it appears that the FOMC may raise the rates, the mortgage companies will set a higher interest rate for when the loan closes. If rates appear they will remain flat or decrease, they are able to decrease their mortgage rates to stay competitive. 

Essentially, the new inflation data all but guarantees that the FOMC will not raise rates again in December during their next meeting. This allows mortgage companies to reduce the interest rates they charge to consumers as they have more confidence in their margins staying the same. So, the question on everyone’s mind is when will rates return to “Normal”?

The answer is, it depends. Also, we must define what “Normal” even is after our COVID years and insanely low 2% interest rates. If you average out mortgage rates over the last 5 years you’ll land in the 4.85 – 5.15% range and over the last 10 years it’s closer to 5 – 5.35%. This means that the Federal Funds Rate would need to be in the 2.5 – 3.5% range, where we are currently at 5.35%. This means that rates will need to drop approximately 2 points to get to a funds rate that would allow for mortgages to return to a “normal” range. 

The FOMC meets nearly every month to make decisions on adjustments to the Federal Funds rate. They’ve made it clear over the last year that they will continue to increase and hold rates as long as they feel necessary to reach their benchmark inflation rate of 2%. Now that inflation data is getting closer to their benchmark, the FOMC will begin to assess if they can safely reduce the funds rate and not spike inflation numbers. Since the FOMC increased rates consistently at .25%, it can be expected that when reductions do come it will also be in .25% increments. If the FOMC took a dramatic path to reducing the rates it would take approximately 6 – 8 months to reduce the funds rate to the 2.5 – 3.5% range. Knowing that the FOMC is likely to not to take a dramatic approach to rate reductions, it should be expected that the return of “normal” rates is more likely to take between 8 – 16 months, or Summer 2024 – Spring 2025.

This may feel like a long time from now, but the reality is consumer confidence is already returning to the market and both showing and mortgage application activity have increased significantly in the last 5-7 days. Buyers are more confident that rates will begin to decline and they may only have to carry a higher interest rate for 6-8 months before they can refinance into a lower mortgage rate and payment.  Of course, only time will tell, and we’ll continue to watch the market closely, but appears there is light at the end of this tunnel.