U.S. mortgage applications fell for the first time in four weeks even as interest rates dropped to a six-month low, an industry trade group said on Wednesday, offering more evidence the country's housing market slump is deepening.

The Mortgage Bankers Association said its seasonally adjusted index of mortgage application activity, which includes both refinancing and purchasing loans, for the week ended September 22 fell 4.9 percent to 566.6 from the previous week's 595.8, its highest level since April.

Applications were 21.4 percent below their year-ago level.

James O'Sullivan, economist at UBS Securities in Stamford, Connecticut, said the indexes tend to be volatile on a weekly basis, but the momentum for the market is downward.

Certainly in housing, it's a contraction, he said. If there was such a term for the sector, it would probably qualify as a recession.

Borrowing costs on 30-year fixed-rate mortgages, excluding fees, averaged 6.18 percent, down 0.18 percentage point from the previous week, to its lowest level since February. Interest rates were above year-ago levels of 5.85 percent, but sharply below a four-year high of 6.86 percent touched in June.

Low mortgage rates fueled the most recent housing boom, but last week's plunge in rates failed to lure consumers.

The MBA's seasonally adjusted purchase mortgage index, widely considered a gauge of U.S. home sales, fell 5.5 percent to 375.9. The index was also substantially below its year-ago level of 483.1, a drop of 22.2 percent.

The group's seasonally adjusted index of refinancing applications dropped 4.1 percent to 1,677.5, down 20.4 percent from a year ago when the index stood at 2,106.6. The refinance share of applications rose to 44.3 percent from 43.7 percent the previous week, its highest level since September 2005.

FED MAY CUT RATES

Signs of a crumbling U.S. housing market and worries that the slump may hurt the overall economy are feeding the idea the Federal Reserve will be forced to trim short-term interest rates sooner than many had forecast.

The Federal Open Market Committee, the Fed's policy-making arm, last week voted to keep the overnight federal funds rate target at 5.25 percent for a second consecutive meeting. The central bank said it remained concerned about inflation, but acknowledged the risks to the growth outlook.

Housing is certainly the big story here and I think disproportionately it's been a driver of growth on the upside and now on the downside, O'Sullivan said. If the unemployment rate starts trending up, they clearly will start easing.

O'Sullivan expects the Fed to start lowering interest rates early next year.

MIXED SALES SIGNALS

The MBA's soft data preceded a separate report showing strength in the U.S. housing sector.

The Commerce Department on Wednesday said sales of new U.S. homes unexpectedly rose in August to a seasonally adjusted annualized rate of 1.050 million units after a sharp downward revision in July, while the inventory of homes for sale eased.

New single-family home sales increased 4.1 percent in August from a downwardly revised July rate of 1.009 million.

Despite the stronger-than-expected data, most contend the housing market is in a slump.

On Monday, the National Association of Realtors said the pace of existing home sales in the United States fell for a fifth straight month in August and prices dropped from year-ago levels for the first time in 11 years.

ADJUSTABLE SHARE SHRINKS

Borrowing costs on fixed-rate mortgages have moved significantly lower in recent weeks, while adjustable-rate mortgages have been fairly steady.

The gap between some fixed- and floating-rate loan rates is slim. Fixed 15-year mortgage rates averaged 5.81 percent, down from 6.04 percent. Rates on one-year adjustable-rate mortgages (ARMs) decreased to 5.90 percent from 5.95 percent.

The ARM share of activity decreased to 26.4 percent of total applications from 27 percent the previous week.

The MBA's survey covers about 50 percent of all U.S. retail residential loans. Respondents include mortgage banks, commercial banks and thrifts.

(Additional Reporting by David Lawder and Patrick Rucker)

Mortgage