Inflation seems to be a constant threat, in the news headlines and in your pocketbook. The Federal Reserve (Fed), in an attempt to curb inflation, has started to increase short-term interest rates.
This doesn't mean that it won't have an effect on the economy. We will discuss how rising Fed interest rates impact home buyers and other stakeholders.
Why did the Fed raise interest rates?
The Federal Reserve has two main missions: to stabilize prices and to maintain moderate long-term interest rates. Inflation is a topic of hot debate if you have been following the news.
Although there are many reasons why the economy is experiencing rapid price increases, the Fed is the only one that can control them. Let's take an in-depth look at how this happened.
The global pandemic is a result of three things. There are supply chain disruptions due to the pandemic and more money from COVID-19-related stimuli. Also, sanctions and embargoes against Russian oil as a result of the war in Ukraine.
The U.S. central banks raise the federal money rate to try and curb inflation. The federal funds rate, which is the rate banks borrow from one another overnight, has a significant impact on all interest rates because any other rate a lender sets changes with it. A decrease of less than one percentage point can have a significant impact on borrowing, especially for higher loan amounts.
Rates can go up more than once, and they often do. The federal funds rate has risen by 1.5% in 2022, three times more than it did in 2022. It is currently in the range of 1.5% to 1.75%.
According to the comments and projections of Fed governors, they may increase the fed rate several times this year in increments of 0.5% or greater in the short term, with smaller 0.25% increases in the long term. There is reason to believe that the Federal Reserve will increase the rate by 0.75 percent in July, based on the continued high inflation reports.
The Fed has to balance the desire to reduce inflation with the potential negative economic impacts. These rate increases are designed to make it more difficult for people to borrow money. This slows down spending. The theory is that sellers will reduce or keep prices low if demand falls.
Low-interest rates can also help business expansion. Businesses will expand their operations and hire more people if borrowing is cheaper. You risk spending cooling more if you raise rates too quickly.
Businesses tend to lay off employees when there is less demand. This directly impacts the Fed's other mandate to Congress, which is to create an environment that encourages maximum employment.
A recession can be caused by people not spending enough and losing their jobs. Despite the fact that the economy tends towards cycles, every Fed chairperson would prefer to avoid this. Although there is no limit on how many times the Fed may raise rates, it's still a delicate balance act.
The type of mortgage you have will impact how the federal funds rate affects mortgages. Your mortgage rates will not change if you already have a fixed-rate mortgage and aren't looking to refinance your home or purchase a new one.
There is no direct relationship between the federal funds rate and mortgage rates if you are buying a house or refinancing your home with a fixed-rate loan. Rates are determined based on yields of mortgage-backed securities (MBS), and your financial picture.
Although the Fed has been involved in the MBS markets at different times since 2000, the mechanism is not the same as the federal funds rate.
Your interest rate will be affected more by changes in the federal funds rates if you have an adjustable-rate mortgage (ARM). The MBS market prices determine the initial rate that will be in effect for the first few years of an ARM.
The adjustments could be linked to the prime rate of a bank or to another index that moves in the same direction as the interest rates in wider markets. If the federal funds rate rises, your rate will likely go up at the next adjustment. This depends on the caps in your mortgage contract.
How the Federal Reserve Impacts Home Sellers and Buyers
The Federal Reserve increases the federal funds rate to increase interest rates in the economy. The same goes for mortgage rates.
Let's look at the next sections to learn how rate increases affect buyers, sellers, and homeowners who are looking to refinance.
How home buyers are affected
While mortgage rates and federal funds rates don't necessarily correlate, they tend to be in the same direction. A higher federal funds rate will result in higher mortgage rates for buyers. This has many effects.
- The loan amount you qualify for will be lower. Lenders will preapprove you based on your down payment and your monthly income (DTI). Your monthly payment will be higher so you can afford a smaller loan amount. This could be especially true for first-time buyers who don't have enough money to pay a larger down payment and a lower loan amount.
- It is possible to have trouble finding homes within your price range. Sellers tend to not raise prices as rates rise. They may lower them after a while if they don’t get offers. However, it is important to remember that this might not happen immediately. There isn't enough inventory in the housing market right now to keep up with demand, especially when it comes to existing houses. Pent-up demand may lead to higher prices for a while. Some buyers might be priced temporarily out of the market.
- Higher mortgage payments are associated with higher rates. This could mean that you spend more of your monthly budget on your home.
- It is important to weigh the pros and cons of renting versus buying. With property values rising at an alarming rate, rent costs tend to rise faster than mortgage payments. But every market is unique, so make sure to do the math in your local area.
How home sellers are affected
You may be considering selling your home now that the Case-Shiller 20 city index has shown that home prices have increased 21.23% in the past year. There are many things to keep in mind as rates rise.
- You may find fewer buyers interested. Higher rates could mean that more people are priced out of the current market. It may take longer for buyers to come to your house and it might take some time for them to offer.
- It might be harder to find a home. Realize that even though you might make a large profit on your house, it could cost you a lot more to buy another home. Additionally, you would be paying a higher interest rate.
- It's possible that your home won't sell as quickly. This is because there isn’t enough inventory. Prices will stay high in many areas longer than normal in an environment with rising rates. But, eventually, housing prices will drop. To get offers, you may have to reduce your price.
How homeowners are affected
The federal funds rate rise will have an impact on homeowners. It all depends on what type of mortgage they have and your goals. Let's look at three scenarios.
Your rate will not change if you have a fixed-rate loan and do nothing to it. Your payment can only be affected by changes in taxes or insurance.
Your rate could go up if your adjustable-rate mortgage rate is due for an adjustment. The amount of adjustment and whether it happens depends on the caps in your mortgage contract. Also, how far you are from the market rate when it adjusts.
Refinancing is possible if you have taken out a mortgage in the past. This means that you won't get a lower rate. One thing to remember in this market is that rising prices have meant that many people have equity. This could be positive in debt consolidation.
Interest rates rise everywhere when the Federal Reserve raises its federal funds rate. Although higher mortgage rates are not something that everyone likes, they will always be lower than what you can get on a credit card.
Consolidating debt could help you pay off high-interest debt at a lower rate by allowing you to roll it into your mortgage.