If you’ve been following the news, you know that the Federal Reserve has been raising interest rates. The Fed’s efforts to bring inflation under control by raising interest rates affect many aspects of our lives in a very real way.
In particular, Fed policy impacts home affordability and sales activity. But before we dive into how exactly rising interest rates affect housing, let’s first get some background on what the Fed does in general and what the federal funds rate is specifically.
The Fed Raises the Federal Funds Rate
The federal funds rate is the interest rate banks charge each other for overnight loans. It’s one of several tools that the Federal Reserve, or Fed, uses to control the economy. When the Fed wants to slow down an overheated economy, it raises the federal funds rate. That makes borrowing money more expensive — and that can put a damper on consumer spending and business investment in things like factories and equipment.
When inflation gets too high, the Fed tries to cool things off by increasing rates again, so people borrow less money from banks and spend less on goods and services.
A Fed Rate Increase Affects Mortgage Rates, Making Them More Expensive for Buyers
The federal funds rate is a benchmark for other interest rates, including mortgage rates, which are tied to it. When the Fed raises its benchmark, it makes borrowing more expensive — which can slow down economic growth and inflation.
The Fed raised its key short-term interest rate by half a percentage point on Wednesday, in line with previous increases but smaller than the four hikes it made earlier this year.
The Fed also predicted that economic growth would be slower, unemployment higher and inflation rates rising in 2023.
Lower growth rates typically lead to lower interest rates over time, including mortgage rates, according to Mike Fratantoni (chief economist for the Mortgage Banker’s Association).
“The housing market has certainly welcomed the recent decline in mortgage rates,” he said. “This decline is reflecting market expectations of being near the peak for short-term rates, as well as increased signs that the U.S. is headed for a recession next year.”
In General, Higher Mortgage Rates Are a Bad Thing for the Housing Market
In general, higher mortgage rates are a bad thing for the housing market. As mortgage rates rise, home buyers have to pay more in interest on their mortgages. In turn, that means that they have to put down larger down payments and save more money for closing costs. If you’re wondering how this impacts the housing market, let’s take a look at some real-world examples:
- If you’re an existing homeowner thinking of selling your home and buying another one (or renting), a rise in interest rates will make it more expensive for you to buy or rent another property. This will keep some folks from selling their homes and moving elsewhere due to rising prices of other properties such as rentals or new builds (and therefore lower demand). We are already experiencing that in today’s market. Sellers are having a hard time justifying going from the current 3% mortgage rate to over 6% when they buy a new home.
- First-time buyers who want a house but don’t have enough savings already may not be able to afford higher mortgage payments because those monthly costs would eat into much-needed funds needed elsewhere, like paying off other debts first before even considering buying a home!
Raising Interest Rates Impacts Housing Affordability and Causes Sales Slowdowns
The Federal Reserve has been raising interest rates since early this year. This is because inflation is a bad thing for the economy. When inflation goes up, it means that prices are rising and money becomes less valuable. As such, higher rates make it harder to pay off loans, which could eventually lead to defaults if people can’t afford their mortgages anymore.
Higher mortgage rates are especially harmful for the housing market because they affect home sales volume (fewer people buy houses), down payments (fewer buyers can afford homes), and home values (more expensive homes).
New Home Sales Are Reacting to Rates More Than the Resale Market
In an effort to get buyers back in the market, single-family home builders have been offering incentives and cutting prices on new homes.
According to data from the National Association of Home Builders and Wells Fargo’s Housing Market Index (HMI), 35% of single-family home builders reported reducing their prices in November — with nearly 3/5 offering special sales incentives.
Although these percentages seem high compared to a few months ago, they were still far below where they were during the great recession when around 50% of builders cut prices and almost 3/4 offered sales incentives.
If you’re looking to buy a home, the higher rates are definitely something to be aware of. But do not despair! The good news is that there are other options out there that can help you get into your dream home without breaking the bank. For example, if you’re willing to wait until rates go down again (which we expect them to), then waiting until next year may be an option for some buyers.
Home prices may also decline further, which would make home buying even more affordable next year. We have already seen some areas adjusting in prices, and with the current economic conditions, prices will probably adjust further.