Impact of the federal funds rate on mortgages
The federal funds rate, and by extension banks’ prime rate, create a benchmark for the cheapest available loans. But the relationship between mortgage interest rates is imperfect.
From 2009 to 2015, as federal funds held constant, mortgage interest rates varied month-by-month. The average 30-year fixed mortgage rate was 5.04 percent in 2009, 4.45 percent in 2011, 3.66 percent in 2012 and 4.17 percent in 2013, according to Freddie Mac.
This might not sound like a big difference, but when it’s compounded over the length of a 30-year mortgage, these fractions add up.
Over the past 45 years, interest rates on the 30-year fixed-rate mortgage have ranged from as high as 18.63% in 1981 to as low as 3.31% in 2012. Mortgage rates today are at historical lows, although the Fed indicated that it will probably increase rates two or three times throughout 2018. As of March 2018, the rate is 4.45%. (Source: Macrotrends.net)
Let’s say that you borrow $250,000 at a 4.17 percent interest rate. The interest payments alone, over the span of 30 years, would come to $188,541, according to MortgageCalculator.org. That doesn’t include principal, homeowners insurance and property taxes. If you borrowed that same $250,000 at a 4.45 percent interest rate, the interest payments over 30 years would come to $203,364. In other words, you’d be spending an additional $14,823 on the same loan.
But why did the mortgage interest rates fluctuate so much? If mortgage interest rates moved in lockstep with changes to the Fed’s monetary policy, these years wouldn’t show such wide variation.
But mortgage rates are influenced by more than just the prevailing federal funds rate. They’re also influenced by Department of the Treasury yields, investor sentiment, and inflation rates, among many other factors.
And not all types of mortgages are impacted in the same way. Every lending institution, such as banks and credit unions, chooses the interest rate for their mortgages. These mortgage rates vary based on a wide variety of factors, including length (such as 15 years vs. 30 years), dwelling use ( primary residence vs. investment property), and terms (fixed vs. adjustable).
Adjustable-rate mortgages, which are modified annually, are more impacted by federal rate hikes than new fixed-rate mortgages, according to USA Today.
The creditworthiness of a borrower also impacts the type of loan and interest rate for which they qualify. Borrowers with a lower credit score or a smaller down payment might get hit with a higher interest rate, or might be required by the lender to buy mandatory mortgage insurance. This results in higher monthly payments, which limits how much home a buyer can purchase.
Insight: Adjustable-rate mortgages, which are modified annually, are more impacted by federal rate hikes than new fixed-rate mortgages.
Conversely, a borrower with a 20 percent down payment and a strong credit score might qualify for the lowest interest rate that the lender offers. As we discuss below, this means the borrower can qualify for a larger loan.
What could happen to housing prices?
That said, there are two questions at hand: How could interest rate changes affect the housing market in general, and how could it affect your ability to buy or sell your own home?
Let’s start by looking at the overall market.
Mortgage underwriters approve homebuyers to borrow up to a certain maximum amount, based on the home value (through a ratio called loan-to-value), the borrower’s income (through a metric called the front-end ratio), and the borrower’s other debts (through a metric called the back-end ratio).
If mortgage interest rates rise and everything else stays the same — borrowers have the same income and same debt levels — the borrower won’t qualify for as expensive of a mortgage as they previously could. For example, if a borrower qualifies for a maximum monthly payment of $2,000 per month, and mortgage rates rise, then interest will gobble up a bigger chunk of that $2,000, leaving less space for principal.
This could put home buying out of reach for some or put stagnant or downward pressure on home prices.
Changing interest rates can make quite a difference for home buyers and sellers. For example, a 0.5% rise of the interest rate can result in a 6% increase in the monthly mortgage payment (our numbers include monthly principal and interest only) and a ~5.8 decrease in house purchasing power.
But an alternate scenario could also unfold.
If employment rises, or salaries and wages grow, or consumer debt falls, or lending criteria loosens, then borrowers may still qualify for similarly-sized or larger mortgages.
For example, if a potential homebuyer gets a $10,000 annual raise and their unemployed spouse finds part-time work, then their borrowing qualifications improve. If they use some of this additional income to pay off their consumer debt, then their borrowing qualifications improve even more.
Sure, interest rates may rise. But this uptick could be offset by other economic factors that improve borrowers’ positions.
In fact, higher interest rates often correlate with more lending, a stronger U.S. dollar, and more interest income from savings vehicles, according to Bankrate.
What might happen? It depends.
Insight: Higher interest rates often correlate with more lending, a stronger U.S. dollar, and more interest income from savings vehicles.
The outcome isn’t as simple as assuming higher interest rates are bad for the housing market. A variety of factors, from wages to employment to lending requirements, influence the number of homebuyers in the market and the maximum price of homes for which they qualify. And this impacts everything from median sale prices to the average number of days-on-market.
Furthermore, real estate markets are inherently local.
For example, Las Vegas has undertaken several major spending projects. They include the construction of a $1.8 billion NFL stadium, as the Las Vegas Review-Journal reports, and a $30 million upgrade to its downtown entertainment district, according to Las Vegas Now. Nevada also had the fastest job growth in the U.S. in 2017, according to the Las Vegas Review-Journal. This growth will impact the local housing market, likely stimulating the economy with more jobs, but potentially driving up prices.
What should you do if you’re buying?
If you’re thinking about buying a home, focus on becoming a well-qualified buyer. This might involve negotiating for a raise, paying off your loans, or saving for a strong down payment so that you secure a better loan-to-value ratio.
Learn about the many mortgage options available, such as Federal Housing Administration loans, Veterans Affairs loans and US Department of Agriculture loans, which may expand the range of properties for which you qualify.
Shop around for your mortgage. Lenders will offer different rates, and you might shave thousands from your total interest payments by comparison shopping.
What should you do if you’re selling?
If you’re thinking about selling your home, focus on the factors within your control, such as repairs, curb appeal, painting, decluttering, and staging. The classic principles of selling a home — ensuring it’s in good condition, clean, and well-photographed — remain true in all markets.
Timing the sale of your home is always tricky, and trying to sell based on interest rate hikes may not help. It might be tempting to rush to list your home before the Fed next convenes, but other factors, such as the season, local wage growth, and population increases also impact market conditions. Interest rates may dominate the headlines, but they’re only one of many variables.
Contact me about Selling or Buying Your Home in Massachusetts
Bobbie Files is a Real Estate agent at SUCCESS Real Estate, covering the Bristol, Plymouth and Norfolk County areas